Defining the Federal Reserve's role

  • Published: January 16, 2014
  • Runtime: 7:19
As the central bank closes in on its 100th anniversary, James Grant, editor of Grant's Interest Rate Observer, and Richard Sylla, professor of economics at NYU Stern School of Business, debate its true purpose.
This week on WealthTrack as the Federal Reserve celebrates its 100th birthday, is it a cause for rejoicing or despair? Two financial historians, NYU's Richard Sylla and Grant's Interest Rate Observer's James Grant debate the case for lighting candles or snuffing them out- next on Consuelo Mack WealthTrack. I began the interview by asking them to go back to basics: what is the role of a central bank? -Well, one might start with the role it was assigned in legislation 100 years ago. It was to lend against sound collateral. It was to create a market in commercial paper, meaning business loans. It was to furnish so-called elastic currency and it has to be a lender of last resort, and that was it. Oh, yes. They added "and for other purposes" and we have all too many of the other purposes, but my suggestion is the Fed think more about the roles for which it was created rather than the ones it has arrogated to itself. -Dick? Since the 1970s, the Federal Reserve has had the obligation to stabilize the price level. That was there for a long time, but an added obligation was to generate high levels of employment. -Right. -And so this is called the dual mandate. The Fed had a dual mandate. We talked for the last 30 years about the dual mandate of the Fed. The Dodd-Frank Act of 2010, I think, they added another item. The Fed is not only supposed to stabilize the price level and give us the maximum amount of employment, but it's also to foster financial stability. So, the Fed now has those three things to do. -So my question, though, is what do you think the role should be? We know there's this long litany of ever-expansive roles that it has, so-- -Well, Dick has just told us what it can't do. -What-- Would you say that was one of the original goalsz/ -Yeah. I mean I think traditionally-- traditionally a central bank was responsible for stable prices, and that happens to be what they might be pretty good at, you know, that's-- Most of economists, I'm one, think that the Federal Reserve actually has the power, the tools to stabilize the price level. There's a lot of evidence in favor of that. It's much less certain that they can do much to, you know, change the unemployment rate, reduce the unemployment rate. -See, the Fed has got into its head that it can improve the future before it comes to pass. The Fed has morphed from central banking into a kind of a seat of the pants central planning. It has these models don't you know, very, very complex, a lot of differential equations. They don't work, but they do give the Fed the seeming intellectual authority to do so many things that common sense would tell you that simply the Fed cannot do. For example, the Fed now is in the business of manipulating the structure of interest rates. It is in the business of suppressing some interest rates, and new thing, it is in the business of talking up the stock market. In other words, the Fed-- as Dick mentioned stabilizing prices. The Fed is manipulating prices, especially on Wall Street. It's a very new thing. -Has it been an effective price stabilizer? And stabilizing prices I'm assuming means that they don't go up or down too much. -I would say in the long run the Fed has not really been all that effective, because the 20th century was a three percent inflation century. You know, there were some low inflation, some very high inflation, but you know, you can compare it with the previous period of the 19th century when prices in 1914 were not very different from what they were in 1815 according to pricing. So, the 19th century was a zero inflation century without the Federal Reserve. When the Fed came in, we had basically a three-percent inflation trend ever since then, but I don't think we can entirely blame that on the Fed. There was something called World War I. There was something called World War II, and-- -The Korean War, The Great Society Program. -Yeah, and if you look back at those periods, it turns out the Federal Reserve was sort of conscripted to be part of the government's financing machine, and the Secretary of the Treasury told the Fed what to do. In World War I, it was to lend a lot of money to banks so they could buy first liberty bonds and then victory bonds. In World War II, the Secretary of the Treasury commanded the Fed to keep the interest rates no higher than two and a half percent on long-term bonds and three eighths of one percent on a Treasury bill, and so the Fed was told what to do. We did not have an independent central bank. So I'm saying there's-- you know, -Until 1951. Right. -1951. Then the Fed was freed from the control of the Treasury but, of course, the worst inflation we had was from 1965 or '66 through 1981, which ended up with a double-digit inflation in '79 to '81, and the Fed had a lot to do with that inflation. It was using the wrong models. Jim talked about the Fed uses the wrong models. I think they were definitely using the wrong models in the 1970s. Then Paul Volcker came in. He knew what to do, -Right. -and he's become sort of an American hero since that time, and you know, 30 years after he whipped inflation, now he has his Volcker Rule passed. -So Jim, would you give the Fed the role of stabilizing prices? Is that a fair role to give? -No, no, no. Prices ought to be determined, it seems to me, through what they call future price discovery; that is to say, the unplanned and unmanipulated dynamics of free people making choices in the marketplace. You know, at the time of terrific technological progress one would expect the general price level to kind of dwindle, right? Because every day lower and lower prices is how Walmart's made a pretty good business about that. Prices dwindled a percent or so a year, one and a half percent or so a year in the last quarter of the 19th century. People kind of liked that. They regarded it as a sign not of deflation but of progress. Now we have a Fed that wants us to know that prices must not go down. Well, in order to assure the prices don't go down, the Fed creates lots and lots of credit that creates lots and lots of distortions, some of which end up from time to time in crises. So that the Fed is getting-- This price stability is a very glib thing to say. -Right. -It sounds very, very-- It sounds commonsensical off of the tongue but it is, in fact, not so. -So, I guess the issue is, can any institution really in an economy such as ours and in a world that we live in which is so dynamic, really be, you know, chartered? -Well, no. If it could, the Soviet Union would still be in business. -Right. -The idea of the humble, but wonderful institution of the price mechanism, the price system, is it is what makes free economies work. It's what-- It's how work is measured and how goods are allocated. It's a pretty cool system, and the Fed without an explanation really why is interposing itself between that system and us.

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