by Scott Bessent at International Economy
Overuse of nonstandard policies, mission creep, and institutional bloat are threatening the central bank’s monetary independence.
As we saw during the covid pandemic, when lab-created experiments escape their confines, they can wreak havoc in the real world. Once released, they cannot easily be put back into the containment zone. The “extraordinary” monetary policy tools unleashed after the 2008 financial crisis have similarly transformed the U.S. Federal Reserve’s policy regime, with unpredictable consequences. The Fed’s new operating model is effectively a gain-of-function monetary policy experiment. The Fed’s adoption of large-scale asset purchases as a tool of monetary policy when its traditional instrument—the overnight interest rate—was at the zero lower barrier created severe distortions in the market, with unintended consequences. And it has disturbed the Fed’s unique independent role in the U.S. political system. Central
bank independence is fundamental to the economic success of the United States. The Fed must change course. Its standard monetary policy toolkit has become too complex to manage, with uncertain theoretical underpinnings and problematic economic consequences. Gain-of-function monetary policy must be replaced with simple and measurable policy tools to achieve a narrow mandate. Such an approach is the clearest and most effective way to deliver better economic outcomes and safeguard central bank independence over time.
UNCONVENTIONAL MONETARY EXPERIMENTS, NOT POLICY
In the aftermath of the 2008 financial crisis, the Fed was understandably determined to help revitalize the American economy. It had just successfully modernized its traditional responsibility as a lender of last resort, helping to stabilize the financial system. This role, as described by Walter Bagehot in Lombard Street (1873), is a time-tested function for central banks in managing liquidity crises. While the
complexity of modern credit markets necessitated innovations in program design, the principles guiding the Fed’s intervention were well-worn.
Buoyed by its perceived success in combating the financial crisis, the Fed began placing increasing faith in its ability to steer the economy. This confidence was reinforced by growing frustration with political gridlock in Washington, which appeared unable to address the economic damage inflicted by the Great Recession. The mantra that “central banks are the only game in town” gained widespread traction amongst policymakers.
Against this backdrop,…
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