The Conduct of Monetary Policy
In this essay at the CATO Journal, Kevin M. Warsh writes that the Federal Reserve’s independence is essential to the conduct of monetary policy. But while the Fed is independent within govern- ment, it is not independent of government. The grant of authority to the Fed comes from Congress, to which the Fed is ultimately accountable. In my view, the Fed was granted significant powers by Congress, but those powers were not unlimited. The grant of author- ity was constrained. So by my measure, the Fed is a powerful institu- tion, but a bounded one.
The limits on the Fed in the conduct of monetary policy—that is, limits in the grant of government powers and in the efficacy of its actions to facilitate economic growth—are too often forgotten in Washington. We should acknowledge and understand these limits, not seek to manage or circumvent them.
Many leading econometric models used by central bankers, and promoted in the academy, suggest that the more the Fed pushes down long-term interest rates, the more that policy actions can be deployed to grow GDP, thereby maximizing employment and mini- mizing the output gap. The law of diminishing returns, however, applies to financial markets and the real economy, and some leading models are unable to account sufficiently for this nonlinearity.