What’s a Central Banker To Do?

The FOMC is meeting tomorrow and Wednesday, and it seems as if everyone is weighing in with advice for Ben Bernanke and company. But you can always count on the Wall Street Journal editorial page to dish up something especially fatuous when the topic turns to monetary policy and the Fed. This time the Journal turns to George Melloan, a former editor and columnist at the Journal, to explain why the market has recently turned “skittish” in anticipation that the Fed may be about to taper off from its latest venture into monetary easing.

Some of us have been arguing that recent Fed signals that it will taper off from quantitative easing have scared the markets, which are now anticipating rising real interest rates and declining inflation. Inflation expectations have been declining since March, but, until the latter part of May, that was probably a positive development, reflecting expectations of increased real output under the steady, if less than adequate, policy announced last fall. But the expectation that quantitative easing may soon be tapered off seems to have caused a further decline in inflation expectations and a further increase in real interest rates.

But Melloan sees it differently

We are in an age where the eight male and four female members of the FOMC are responsible for whether securities markets float or sink. Traders around the world who in better times considered a range of variables now focus on a single one, Federal Reserve policy. . . .

In the bygone days of free markets, stocks tended to move counter to bonds as investors switched from one to the other to maximize yield. But in the new world of government rigging, they often head in the same direction. That’s not good for investors.

Oh dear, where to begin? Who cares how many males and females are on the FOMC? Was the all-male Federal Reserve Board that determined monetary during the Great Depression more to Mr. Melloan’s liking? I discovered about three years ago that since early in 2008 there has been a clear correlation between inflation expectations and stock prices. (See my paper “The Fisher Effect Under Deflationary Expectations.“) That correlation was not created, as Melloan and his colleagues at the Journal seem to think, by the Fed’s various half-hearted attempts at quantitative-easing; it is caused by a dangerous conjuncture between low real rates of interest and low or negative rates of expected inflation. Real rates of interest are largely, but not exclusively, determined by entrepreneurial expectations of future economic conditions, and inflation expectations are largely, but not exclusively, determined by the Fed policy.

So the cure for a recession will generally require inflation expectations to increase relative to real interest rates. Either real rates must fall or inflation expectations (again largely under the control of the Fed) must rise. Thus, an increase in inflation expectations, when real interest rates are too high, can cause stock prices to rise without causing bond prices to fall. It is certainly true that it is not good for investors when the economy happens to be in a situation such that an increase in expected inflation raises stock prices. But that’s no reason not to reduce real interest rates. Using monetary policy to raise real interest rates, as Mr. Melloan would like the Fed to do, in a recession is a prescription for perpetuating joblessness.

Melloan accuses the Fed of abandoning free markets and rigging interest rates. But he can’t have it both ways. The Fed did not suddenly lose the power to rig markets last month when interest rates on long-term bonds rose sharply. Bernanke only hinted at the possibility of a tapering off from quantitative easing. The Fed’s control over the market is supported by nothing but the expectations of millions of market participants. If the expectations of traders are inconsistent with the Fed’s policy, the Fed has no power to prevent market prices from adjusting to the expectations of traders.

Melloan closes with the further accusation that Bernanke et al. hold “the grandiose belief . . . that the Fed is capable of superhuman feats, like running the global economy.” That’s nonsense. The Fed is not running the global economy. In its own muddled fashion, the Fed is trying to create market expectations about the future value of the dollar that will support an economic expansion. Unfortunately, the Fed seems not to have figured out that a rapid recovery is highly unlikely to occur unless something is done to sharply raise the near term expected rate of inflation relative to the real rate of interest.


11 Responses to “What’s a Central Banker To Do?”

  1. 1 Bob Athay June 17, 2013 at 11:04 pm


    First of all, thank you for making a subject that I once thought rather dull far more interesting than I previously imagined. Good stuff.

    By temperament and training I’m an applied math & science geek. From that perspective, it isn’t hard to follow what you’re saying and apply the kind of first-order sanity check that I’m used to doing with any sort of systems analysis problem. It all makes good sense to me. What I can’t understand at all is where people like Melloan are coming from.


  2. 2 Marcus Nunes June 18, 2013 at 4:57 am

    The Fed really botched up ‘communications’ by introducing the word ‘taper’!


  3. 3 maynardGkeynes June 18, 2013 at 6:23 am

    I thinks Melloan’s point is that when bad news in the real economy makes the markets go up, something is wrong, and that “something” is Fed policy. How would you answer that?


  4. 4 PeterP June 18, 2013 at 6:29 am

    I think your post is a bit self contradictory. How can the Fed manage expectations if it is not running the economy? If it did manage expectations it would in fact be running the world economy, but it can’t.

    Each time monetarists are asked to show mechanisms they either invoke some stuff that is experimentally not detectable (expectations Imp) or mechanisms that cannot work in the real world (like the hot potato effect or the money multiplier effect).


  5. 5 Benjamin Cole June 18, 2013 at 6:55 am

    Melloan introduces “gender-o-nomics.”

    What is the gender make-up of the House Ways & Means Committee? After all tax policy is made there. And the Senate Budget Committee?

    One problem: When Arthur Burns declared defeat in the Fed battle against inflation, I think the FOMC was all male, back in the 1970s. Maybe Melloan thinks there is a correct balance of men to women on the FOMC that must be reached….

    Actually, whoever Melloan is, I sense he is grappling for traction, but can’t find any. His op-ed seems adrift, calls for higher interest rates to promote growth?

    Why are Treasury auctions oversubscribed? Supply and demand? What makes any rate the Fed chooses rigged or otherwise?

    Is Melloan short the bond market?

    Or does Melloan just feel good at pompously pettifogging against loose money, the sort of declaration one can make when actually insights are lacking…..


  6. 6 maynardGkeynes June 18, 2013 at 8:56 am

    @Benjamin Cole:

    “What makes any rate the Fed chooses rigged or otherwise?”

    I’d be curious to hear you answer your own question.


  7. 7 Peter K. June 18, 2013 at 10:34 am


    I think your comment is lacking. You’re debating semantics.”

    “How can the Fed manage expectations if it is not running the economy?”

    It can try to manage expectations. It might succeed or fail. It can “manage” credit markets. Why the need for hyberbole like “running” the economy?

    Does the government “run” the economy via fiscal policy? It interacts with the private sector via taxes and spending.

    “Each time monetarists are asked to show mechanisms they either invoke some stuff that is experimentally not detectable (expectations Imp) or mechanisms that cannot work in the real world (like the hot potato effect or the money multiplier effect).”

    The evidence I have seen is that whenever inflation expectations have dipped in recent years, the Fed has done a QE and they went back up. Of course correlation is not causation but still.

    Above the zero bound, the Fed lowers interest rates to help boost spending and boost demand. QEs are just a different way of doing this.

    I don’t see how you can argue that the Fed has not had an effect on the economy these past 4 years.


  8. 8 Philo June 18, 2013 at 11:15 am

    “Traders around the world who in better times considered a range of variables now focus on a single one, Federal Reserve policy.” If you can count on Federal Reserve policy to fall within a narrow range, you can focus on other factors. If you must fear that Federal Reserve policy may be wildly inappropriate (though you hope it will be all right), that policy becomes the overriding factor relevant to your investment decisions. Give us a clear, definite, credible statement of what Fed policy will be and we can focus elsewhere. Give us a Fed with “discretion” and a history of erratic behavior and its future actions must be our main concern.

    “Melloan accuses the Fed of abandoning free markets and rigging interest rates.” That’s the Fed’s job. If you want a free market in dollars, you’ll have to abolish the Fed.


  9. 9 Philo June 18, 2013 at 11:18 am

    @ maynardGkeynes:

    “Melloan’s point is that when bad news in the real economy makes the markets go up, something is wrong . . . .” What that shows is that the market distrusts the Fed, expecting that good news would lead the Fed to inappropriately contractionary action.


  10. 10 maynardGkeynes June 18, 2013 at 12:03 pm

    @ Philo: Thank you for your answer. “Inappropriate” contractionary action, or any contractionary action? When was the last time that the stock market reacted positively to a Fed tightening?


  11. 11 Benjamin Cole June 19, 2013 at 10:14 pm


    I do not know the answer to my question. It seems to me the market somewhat set rates, not the Fed. Especially in ZLB.

    Unless the Fed executes aggressive QE, all it can do is “push on the string.”

    It can try to raise rates, but that will only lower long-term rates, I suspect….


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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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