Miracle Workers

inSight

15 Mar 2001

Miracle Workers

Are we expecting too much from the Fed?

It is an enviable position to be in when a central bank can command the trust, respect and support of the people it serves. To attain that level of credibility is, of course, not easy. There is a need to build up a track record of consistently doing the right thing, even though such action often involves inflicting pain on the community. A high degree of credibility makes the achievement of policy objectives easier than would otherwise be the case. What the central bankers say can become self-fulfilling and what the central bank does can be a lot more effective. But, as with all good things in life, you can have too much of it. When it gets to a situation in which there is the expectation and belief that the central bank will always ride to the rescue on almost any problem relating to money, banking and finance, the risk of disappointment is high.

Watching the US situation from afar, there seems to be a strong expectation among the American people that the Fed will be able to prevent the economic slowdown from deteriorating into a downturn and the downward adjustment in the stock market from deepening. There is also an expectation, though perhaps less strong, that the Fed will be able to prevent the US dollar from weakening, and inflation from rekindling, unemployment from rising and the balance of payments deficit from widening, and to influence the US Administration into giving tax cuts. Even those of us outside of the US hope in earnest that the Fed will be able to deliver all this - in brief, a soft landing - for the benefit of the global economy and global financial markets.

But there is a question we must ask ourselves, if only for the purpose of alerting ourselves to the possible downside risks that we all face against the current uncertain environment. Are we - unfairly - expecting too much from the Fed? We should not forget that there is only one instrument available to the Fed - interest rate. To be sure, there are different interest rates and different degrees in the use of that instrument. There are also the timing and the surprise elements that have been so skilfully deployed, always supported by profound and convincing analysis. But, still, there is only one tool, and it cannot be used simultaneously to crank up the engine, fine-tune the fuel injection, strengthen the bumper, oil the shock-absorber and give the many trusting passengers a smooth ride.

Having regard to the experience in other jurisdictions, my answer to the question is, I am afraid, an affirmative one. Yes, we are expecting too much from the Fed. The great majority of jurisdictions outside of the US have eschewed pursuing multiple objectives in monetary policy, for fear of undermining the credibility of that policy, whatever it happens to be. Some have even defined the single objective in very explicit quantitative terms, in the form of an inflation target, and for us, an exchange rate target, and refrained from getting involved in, for example, promoting growth and employment. Yet there is no doubt that the Fed has been successful in frequently switching its monetary policy focus from one desirable objective to another. The record speaks for itself.

The further question to ask, therefore, is why it is possible that the Fed can perform a task that is considered almost impossible by other central banks. I am afraid I do not have a convincing answer to this question, other than the perception perhaps that Alan Greenspan has the capacity for miracles. There may well be an element of truth in this. But, seriously, I can only point to a number of factors that combine to produce that enviable environment for the Fed. These include the sheer size of the US economy, its relatively low degree of external orientation (or dependency on trade), and the lack of a clear alternative home for global capital. The use of interest rates under these circumstances is a lot less likely than in less favourable circumstances to lead to exchange rate, price, financial market, trade and other effects that negate or even over-compensate the interest rate effects.

Joseph Yam
15 March 2001

 

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