In my first year of graduate school a professor offered my class a warning: “There is only one thing we know for certain in macroeconomics,” he cautioned. “Bad monetary policy can do a lot of damage, but we don’t know what good policy can really achieve.”
Fourteen years and $4.4 trillion later, that advice sounds dated. Many agree the Federal Reserve’s extraordinary policies, like quantitative easing, pulled the American economy from the brink at the height of the last recession. But my professor’s warning may explain why central bankers are under fire today. My colleague Peter Coy worries a Republican congress may be out to curb Fed Chair Janet Yellen’s power. In Europe the national bankers, especially from Germany, are trying to block or discredit European Central Bank President Mario Draghi. This could foretell the end of the central banker power bubble.
A recent essay by Harvard economist Ken Rogoff warns that’s a risk. A compelling narrative has emerged since the Greenspan era, he writes, that casts the central banker as a powerful technocrat who can foresee where the economy is headed, keep it robust without risk, and buoy the stock market at the same time. The markets and media hang on the technocrat’s every word. Expectations of central bankers have heightened since the financial crisis because legislative bodies largely stayed away from fiscal stimulus.
Under these circumstances, the bubble the Fed should worry about isn’t in financial markets or housing, but in its own reputation. Writes Rogoff:
These other factors have combined to create a bubble around central-bank pronouncements and decisions that grossly exaggerates their economic significance.Is this a bubble that central bankers should worry about? The answer is clearly yes. The news bubble is of particular concern, because it reinforces the idea that central bankers somehow care disproportionately about financial markets, which is generally not the case.Most central bankers really are targeting growth, inflation, and financial stability, if not necessarily in that order. The political bubble is an inevitable product of central-bank independence, and preventing monetary policy from becoming a target for elected officials requires constant effort. The predictability bubble is perhaps the trickiest to navigate, though my instinct is that less would be more. Exaggerated importance is one kind of bubble that central bankers should always be eager to burst.
When the Fed becomes more visible, it attracts more attention—most of it not helpful. In some ways the bubble Rogoff describes is more dangerous than a stock bubble, because it threatens financial stability and possibly Fed independence. Richard Fisher, the hawkish president of the Federal Reserve Bank of Dallas, defended Fed independence on Bloomberg TV, saying, “Nothing’s changed—it’s just changed parties. … Think about this: Here’s a Congress that can’t get its own budget together. Do you want it running the central bank?”
Fisher is probably right: Fed independence is now under more serious threat than ever. But an increased reliance on monetary policy, coupled with unrealistic expectations, undermines the Fed’s ability to stabilize the economy. The Fed doesn’t really have much sway over the long-term real economy; what little it does have hinges on its credibility. If the Fed says it will keep inflation at 2 percent, and people believe it, contracts and investment decisions are made with that in mind. The 2 percent inflation target becomes a self-fulfilling prophecy. The certainty around Fed targets emboldens risk-taking and growth. If the Fed loses its credibility, its tools are less effective.
Central bankers are among the most powerful people on the planet. But as Rogoff points out, the only way they can maintain unchecked power is by setting humble and realistic expectations on what they can do. That may require popping their own power bubble.
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