The Fed Itself Is of Greater Significance Than Janet Yellen

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Janet Yellen, President Obama's nominee to head the Federal Reserve, faces the Senate Banking Committee this week, providing an opportunity for lawmakers to acquaint themselves with Bernanke's successor. Some commentators have raised questions about whether her nomination would be challenged, but her career in government and academic qualifications should moot any such concerns. Clearly, Yellen is as capable as Larry Summers, or any other nominee President Obama would consider. What is more interesting, however, may be an attempt by Sen. Rand Paul (R-Ky.) to demand a vote on the "Audit the Fed" legislation, which would shed some light on just how the Federal Reserve conducts business. This is important because it is the credibility of the institution, not its leader, that has been in question.

This is not to say that Yellen will not face challenges as the head of the Federal Reserve. Through the various iterations of quantitative easing, the Fed's balance sheet has ballooned to almost $4 trillion-and the Fed continues to add to it at the rate of $85 billion a month. Nonetheless, economic growth remains sluggish, and unemployment has been higher than 7 percent for almost five years. Quantitative easing cannot continue indefinitely, and how the Fed extricates itself may be a true challenge. Ben Bernanke's mere mention of a "taper" had markets tumbling, sending jitters through those addicted to easy money. The next chair of the Fed will need to make some tough decisions.

Yellen's critics have accused her of being dovish when it comes to Fed policy, meaning she is more concerned with unemployment than pursuing monetary policies that promote economic growth. Whether she's a dove or a hawk, this distinction is another curious byproduct of the institution, one that contains significant implications about how the Fed conducts business. Specifically, the Federal Reserve currently operates under a dual mandate adopted in 1977. Under this mandate, the Fed is required to act so as to promote maximum employment and stable prices. Rooted in the Keynesianism prevalent at the time, the mandate promoted discretionary monetary policy where changes in the money supply could affect economic activity.

This policy emerged from an assumption that there was an inverse correlation between inflation and unemployment, and monetary policy could be used to exploit this trade-off. However, Nobel laureates Edmund Phelps and Milton Friedman refuted this theory. With his natural rate of unemployment hypothesis, Friedman demonstrated that attempts to push employment beyond that rate would only be inflationary, with no ability to lower the unemployment rate over the long run. As a result, the two goals of the dual mandate can be viewed as being at odds with one another; pursuing maximum employment may have adverse effects on prices.

Since the work of Friedman and Phelps, the Fed has often couched its policy goals in terms of price stability, with the assumption that achieving a regime of stable prices will promote long-term economic growth and, therefore, increase employment. Yet, as economist Daniel Thornton notes, in the wake of the economic collapse in 2008, the issue of maximum employment is receiving more attention. As the new chair of the Fed, Yellen will have an important say in the future direction of the Fed. Will the Fed rely on discretionary interventions to boost employment, or will the Fed seek to establish monetary rules that promote economic stability?

The answer will speak volumes about the credibility of the institution. Which is why Sen. Paul's call for an audit of the Fed is of more significance than who the chair is. With the federal funds rate hovering just above zero, the Fed's policies have consisted of primarily padding its balance sheets with questionable assets. And it's not as if the Fed was not complicit in the financial meltdown. Easy credit led to a lot of foolish investments. The Fed has been in business for a century now, and has presided over the Great Depression, the inflationary 70s and the Great Recession of 2008. There have been years of prosperity and years of recession. Perhaps it is time to audit the Fed, identify pitfalls and rethink the role of the central monetary authority.

Ideally, the ultimate goal is establishing monetary policies conducive to economic growth. This requires discipline to resist the call for easy money from both Wall Street and Washington, a task made tougher by the federal government's burgeoning debt problem. Rather than tinker, the Fed should focus on creating a clear monetary rule to avoid economic dislocations and malinvestments. These changes require more than just a new Fed chair; they require fundamental reform, and an audit of current Fed activities is a good place to start.

 

Wayne Brough, Ph.D is Chief Economist and Vice President of Research at FreedomWorks.  

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