Monetary Policy: Lessons from the Past?

One thing about trying economic times, they make a great time for learning as well as teaching. Because of the triple convergence of credit market disruption, rising prices and falling dollar value, this is a great time to review what we know and what we teach about monetary policy and central banking.

One of the early theorists of central banking was Walter Bagehot. He is perhaps as well-known for being one of the early editors of The Economist magazine, he also wrote a classic work of central banking, Lombard Street: A Description of the Money Market. Written when London was the financial capital of the world and gold was the monetary standard, Bagehot managed to write about the role of banks and central banks during times of domestic and international financial crises in terms that have relevance today. This brings us to two articles.

The first article appeared in last Friday's (April 25) issue of The Wall Street Journal. The author, Ronald McKinnon of Stanford University, points toward the works of Bagehot in recommending action to the Federal Reserve. Specifically, he references Bagehot's advice to "lend freely at high rates of interest." The lending is designed to let investors know that money is available. The rate is to reassure investors - particularly foreign investors - that the nation remains a sound place to invest. To this action, McKinnon notes that while the Fed has lent freely (opening lending channels and lending to investment banks), the "high rates of interest" portion of the prescription has been lacking. As a result, the dollar has suffered in foreign markets, and some international capital has withdrawn to pursue other opportunities. In defense of the Fed, there has also been concern about recession, and the lower rates were meant to stimulate the economy at a time when the greatest perceived risk was of a slowdown.

But this brings us to the second article. In today's (April 29) issue of The Wall Street Journal, John L. Chapman of the American Enterprise Institute, says The Fed Must Strengthen the Dollar. Chapman does not allude to Bagehot, but his reasoning is similar. A return to a more vigorous dollar would do much to bring price pressures under control and restore credibility to U.S. financial markets.

Chapman does point to the Phillips Curve as a possible source of problems for policy makers. He believes that there is a misplaced reliance on the curve's trade-off between inflation and unemployment. And while that may be a factor at the central bank, I would hasten to add that the Fed does have a dual mandate to consider. And that mandate of price stability with maximum sustainable growth (and full employment) could provide some incentive to consider the trade-off, even if it has not held up under extreme conditions.

So what does this mean as we teach? In general, we need to be sure our students understand that monetary policy is far from an exact science. They need to understand that when economic policy is focused on one goal, other goals may be negatively impacted (i.e. focus on recession and you may sacrifice price stability and/or foreign exchange). Finally, we are remiss if we don't point out that while the Fed is designed to be "insulated" from political pressure, insulated is not the same as isolated. And since the Fed has a dual mandate, unlike many other central banks around the world that have single mandates of price stability, it has a more complex job - not unlike "walking a tightrope in a windstorm." Schools still involved in The Fed Challenge may want to take note.

I look forward to your comments.