Already on the defensive due to a persistent failure to achieve its stated policy aims, the US Fed was subject to much fresh criticism over the past week, including from the BRIC nations, collectively the largest foreign holders of US dollar reserves. While the dollar remains the world’s pre-eminent reserve currency, there is growing recognition everywhere, except inside the Fed itself, that a choice will soon have to be made: Either the Fed must move to implement a credible, rules-based monetary policy, focused primarily on preserving the purchasing power of the dollar, or the dollar will lose reserve currency status, initiating a vicious spiral of dollar and US Treasury market weakness, which would quickly spill over into the financial system generally. Were that to happen, the current debate about how to reduce the US budget deficit would be promptly settled, as it would become impossible for the US to finance public sector deficits in the first place. Does the Fed, or the government, see the danger? Regardless, investors need not only to see it, but to understand it and to act accordingly. Time may be shorter than I previously thought.


Few US monetary economists have as solid a reputation as Professor John Taylor of Stanford University and the Hoover Institution. In a recent op-ed in the Wall Street Journal, “The Dangers of an Interventionist Fed,” he succinctly and persuasively argues that the Fed is damaging both the economy and its own credibility with serial, extraordinary market interventions. Here is a relevant excerpt:

The combination of the prolonged zero interest rate and the bloated supply of bank money is potentially lethal. The Fed has effectively replaced the entire interbank money market and large segments of other markets with itself.1

Arbitrary intervention in or manipulation of financial markets is anathema to Taylor and other members of the Monetarist, Chicago school of economics, associated with the late Milton Friedman. Rather, the central bank should follow strict rules instead. As long as the central bank can maintain a stable money supply, or at least a stable, low rate of growth thereof, it is assumed that economic stability will generally follow or, at a minimum, that the central bank will not be the source of instability. (Bad economic policy will always be a source of instability, regardless of the quality of monetary policy.)

Taylor goes on to write that consequences of recent and possible future arbitrary actions are likely to be severe, as “the Fed is distorting incentives and interfering with price discovery with unintended consequences throughout the economy”. As I wrote in a similar if less diplomatic vein in last month’s Amphora Report, “Through the Broken Window”:

[I]f policymakers keep mucking around with the marketplace, the economy will not only fail to Reserve system is involved in designing and implementing the strategy. It would offset any tendency for decisions to favor certain sectors or groups in the economy.

improve sustainably on its own; rather, it will descend into a vicious spiral of stagnation, capital flight and eventually an outright decline in living standards.2

Taylor’s proposed solution is to put the Fed back into a rules-based box. Specifically, he recommends that the Congress pass the recently introduced “Sound Dollar Act”:

The Sound Dollar Act of 2012, a subject of hearings at the Joint Economic Committee this week, has a number of useful provisions. It removes the confusing dual mandate of “maximum employment” and “stable prices,” which was put into the Federal Reserve Act during the interventionist wave of the 1970s. Instead it gives the Federal Reserve a single goal of “long-run price stability.”

Long-run price stability. Well isn’t that a nice idea? The problem here is that ever since president Nixon abruptly severed the link between the dollar and gold in August 1971, the Fed has not achieved long-run, rather, only temporary price stability. Taylor is nevertheless confident that the Sound Dollar Act could work, in part due to some additional provisions:

To further limit discretion, restraints on the composition of the Federal Reserve’s portfolio are also appropriate, as called for in the Sound Dollar Act.

And perhaps the most important provision of all:

Giving all Federal Reserve district bank presidents—not only the New York Fed president—voting rights at every Federal Open Market Committee meeting, as does the Sound Dollar Act, would ensure that the entire Federal Reserve system is involved in designing and implementing the strategy. It would offset any tendency for decisions to favor certain sectors or groups in the economy.

This last part is highly significant because it does try to fundamentally reform the distribution of power at the Fed. In a 2010 Amphora Report, “A Century of Money Mischief”, I wrote about how the Fed’s formal voting arrangements invariably favour the large, politically-connected New York banks over their generally smaller, regional counterparts:

[P]lease consider the Federal Open Market Committee (FOMC) voting structure: Whereas each member of the Board of Governors in Washington and the President of the New York Fed always has a vote, only four of the regional presidents may also vote at any one time, on a rotation basis. This implies that, even in the event that all four voting regional presidents dissent from a vote, the Board of Governors in DC and the NY Fed President will nevertheless carry a 2:1 majority! In other words, the power resides clearly at the political centre, not the periphery. And historically, dissenting votes have come overwhelmingly from the periphery.3

Professor Taylor and other proponents of the Sound Dollar Act are thus on the right track: They understand not only that arbitrary monetary policies can be highly damaging to an economy, but also that the Federal Reserve Act, as drawn up in 1913, invariably favours large banks over small, in other words, favours Wall Street over Main Street.

Unfortunately, you can be on the right track and still go off the rails. This is because whoever happens to be driving the train at any point in time is still going to be prone to political influence or simply to making mistakes. To understand this point better, let’s consider a brief history of Monetarist economics.

Monetarism grew out of criticisms of Keynesian policies, which in general place much importance in fiscal policy as a means of managing business cycles. As we know, Keynesian-style demand management fell out of favour in the 1970s, the decade of the dreaded stagflation, and Monetarism, along with Rational Expectations Theory (RET), inspired the explicit monetary-targeting policies of the Volcker Fed, beginning in 1979.

The battle against the 1970s stagflation had been won by the mid-1980s and Monetarists basked in empirical as well as apparent theoretical success. But by the late 1980s, the Fed was at it again, keeping rates lower for longer than implied by money supply and credit growth. A bubble formed in southwestern US real estate and blew up in the late 1980s, crippling the Savings and Loan industry

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