Richard Alford: The Problem of Central Banks With Multiple Goals and Few Tools

By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.

While there are numerous definitions of economics, the most widely used is:

Economics is the study of how economic agents – households, businesses, governments – allocate limited resources across competing uses.

The definition encompasses market, command and mixed economies as the need to allocate resources transcends legal, institutional and other societal arrangements. Various sub-fields of economics have area-specific operational definitions, but the core, the fundamental economic problem, is the same: the allocation of resources. The relative scarcity of resources implies opportunity costs or tradeoffs, e.g., guns versus butter, labor versus leisure, present versus future.

However, current monetary policymakers (largely economists) have designed and employed macroeconomic models and a policy framework that allow only one goal for central banks: price stability. They did not solve the problem of how to allocate scare resources (in this case limited policy tools) in pursuit of competing ends, e.g., stable prices, full employment, sustainable growth, financial stability, external balance. They simply designed models that assumed the problem away and freed central banks from the fundamental problem of finding acceptable, if not optimal tradeoffs when setting policy.

Post the financial crisis, the great recession and in the midst of a painfully slow recovery, economists and central bankers are moving in the direction of flexible inflation targeting, i.e., allowing for the possibility that monetary policy should pursue goals other than just price stability. However, the flexibility appears to be limited to sequential shifts from inflation-only targeting to employment targeting and back. Policymakers are still talking as if they will never be faced with policy tradeoffs.

More recently, and very belatedly, monetary policymakers have acknowledged the existence of a link between monetary policy and financial stability. The existence of the link implies that the Fed faces potential tradeoffs not only between inflation and unemployment, but among inflation, unemployment and financial stability. Given that financial instability implies the possibility of increased unemployment in the future, there are also potential tradeoffs between current unemployment and future unemployment.

With financial stability as a goal in addition to its dual mandate, i.e., price stability and full employment, the Fed has three policy goals. How many resources, aka policy tools, does the Fed have? In terms of monetary policy per se, the Fed has one tool, either interest rates or the quantity of reserves. It also has a set of regulatory tools, but as Yellen has pointed out:

The Federal Reserve has been working with a number of federal agencies and international bodies since the crisis to implement a broad range of reforms to enhance our monitoring, mitigate systemic risk, and generally improve the resilience of the financial system. Significant work will be needed to implement these reforms, and vulnerabilities still remain. Thus, we are prepared to use any of our many instruments as appropriate to address any stability concerns.”

Policymakers do not have the necessary regulatory tools in place. The financial industry also has a well established record of innovating to avoid regulation. Hence, the Fed and other regulatory authorities will likely continue to lag the markets on the regulatory front. Furthermore, financial regulation and supervision will not control the behavior of financial institutions that innovate to avoid regulation, operate outside the regulatory border or across political boundaries. The remote likelihood of a lasting and sufficiently robust regulatory system raises the possibility that there will be times when it is advantageous for a central bank to alter interest rate policy to reflect financial stability concerns.

Interest rate policy also has advantages over regulatory policy in promoting financial stability. Interest rate policy has a non-discriminatory impact on regulated and non-regulated entities as well as across financial products. Furthermore, interest rate policy can alter the incentive that financial entities have to engage in regulatory arbitrage or to innovate to avoid the costs of regulation. This effect has been noted by Fed Governor Stein:

For example, if low interest rates increase the demand by agents to engage in below-the-radar forms of risk-taking, this demand may prompt innovations that facilitate this sort of risk-taking.

Consequently, interest rate and regulatory policies are not independent. The Yellen statement implies that the Fed is prepared to address financial stability concerns with interest rate policy. Plosser of the Philadelphia Fed has said that some members of the FOMC are concerned about the low interest rate policy because of increasing potential costs of financial instability. However, the Fed has not shown any inclination to do so and still asserts that interest rates were not “too low for too long” prior to the crisis. In fact, economists, central bankers and pundits continue to resist calls to acknowledge the possibility that it might be advantageous to design monetary policy with more than just one target in mind. They mustered a number of arguments. They include 1) the Tinbergen separation principle and 2) arguments based on the idea that central banks should specialize/focus on inflation as they have a comparative advantage in maintaining price stability.

Tinbergen Separation Principle

Wikipedia summarizes the Tinbergen separation principle as follows:

Tinbergen, in his work on macroeconomic modeling and economic policy making, classified some economic quantities as “targets” and others as “instruments”. Targets are those macroeconomic variables the policy maker wishes to influence, whereas instruments are the variables that the policy maker can control directly. Tinbergen emphasized that achieving the desired values of a certain number of targets requires the policy maker to control an equal number of instruments.

Tinbergen’s classification remains influential today, underlying the theory of monetary policy used by central banks. Many central banks today regard the inflation rate as their target; the policy instrument they use to control inflation is the short-term interest rate.

Ben Bernanke espoused this position in 2002 when he was a Federal Reserve Governor.

My suggested framework for Fed policy regarding asset-market instability can be summarized by the adage, “Use the right tool for the job.”

As you know, the Fed has two broad sets of responsibilities. First, the Fed has a mandate from the Congress to promote a healthy economy–specifically, maximum sustainable employment, stable prices, and moderate long-term interest rates. Second, since its founding the Fed has been entrusted with the responsibility of helping to ensure the stability of the financial system. …By using the right tool for the job, I mean that, as a general rule, the Fed will do best by focusing its monetary policy instruments on achieving its macro goals–price stability and maximum sustainable employment–while using its regulatory, supervisory, and lender-of-last resort powers to help ensure financial stability.”

Unfortunately, defense of inflation-only targeting via appeals to the Tinbergen separation principle are over simplified and misplaced. The separation principle was derived in the context of a macroeconomic model comprised of well-behaved linear equations. It is clear that real economies include dynamic non-linear relationships between variables and that behavior is at times chaotic.

Furthermore, Tinbergen’s principle was much more nuanced than one instrument for one target. In the context of his model, Tinbergen found that:

1. When the number of policy instruments exceeds the number of targets, policymakers will be able to chose from a menu of possible combinations of instruments to achieve the goals;

2. When the number of instruments equals the number of targets, all targets can be met and one instrument can be used for each goal; and

3. When the number of targets exceeds the number instruments, it will not in general be possible for policymakers to reach all the goals. Policymakers will be faced with having to make tradeoffs across goals. In general, policies will have to be designed with multiple goals in mind, if all targets are to be pursued.
The number of policy goals far exceeds the number of effective instruments.

Regulatory policy has been and is likely to remain incapable of insuring financial stability. Fiscal policy appears to be driven by concerns other than promoting the goals of economic policy, e.g., full employment. International economic policy is non-existent. Consequently, the Tinbergen separation principle should not be invoked to support inflation-only targeting, as the conditions under which it was derived are not met.

Appeals to Comparative Advantage

Central banks, including the Fed, presumably have both absolute and comparative advantages over other policy institutions in maintaining price stability. The exploitation of comparative advantages gives rise to specialization, trade, markets and increased efficiency. To many, this suggests that it is advantageous for the Fed to specialize in maintaining price stability.

However, there are limits to specialization, aka the division of labor. This was noted by Adam Smith in An Inquiry Into The Nature and Causes Wealth of Nations. Chapter III is titled “The Division of Labour is Limited by the Extent of the Market” and includes the following observations:

As it is the power of exchanging that gives occasion to the division of labour, so the extent of this division must always be limited by the extent of that power, or, in other words, by the extent of the market. When the market is very small, no person can have any encouragement to dedicate himself entirely to one employment, for want of the power to exchange all that surplus part of the produce of his own labour, which is over and above his own consumption, for such parts of the produce of other men’s labour as he has occasion for.

In simple terms, the ability of specialization to enhance efficiency and welfare depends not only on the existence of an agent with a comparative advantage, but also on the market and institutional setting.

If the Fed’s goal is to design and implement the optimal monetary policy for an otherwise perfect world, then complete specialization in the pursuit of a single target is appropriate. If the Fed’s goal is sustained stable growth with full employment in a world characterized by market and institutional failures, e.g., other policy tools are either non-existent or incapable of achieving their intermediate goals, then economics suggests that the Fed must accept the possibility that a one-target-only policy may exacerbate resource misallocation and contribute to inferior outcomes.

It is ironic that economists in pursuit of macroeconomic models with microeconomic foundations have adopted models and an operating framework that preclude the existence of the rationale for economics – the relative scarcity of resources and resulting existence of tradeoffs. In so far as inflation-only targeting contributed to the asset price bubbles, the financial crisis and recession, it was costly as well.