A limited central bank

Philadelphia Fed president Charles Plosser gave a noteworthy speech, "A limited central bank." It's especially noteworthy in the context of Janet Yellen's nomination, discussion between Congress and Fed about how the Fed should be run, the Fed's focus on unemployment, and the current state of the hawks vs. doves debate.

We find out what he thinks of micromanaging the taper based on monthly employment reports:

The active pursuit of employment objectives has been and continues to be problematic for the Fed. Most economists are dubious of the ability of monetary policy to predictably and precisely control employment in the short run, and there is a strong consensus that, in the long run, monetary policy cannot determine employment....

When I talk to Fed types about this, the usual answer is a version of "well, yes, we don't really have that much effect on employment, but employment is in the toilet, we have to do what we can, no?"

Charlie has a good answer to that, along the way blasting his colleagues who want the Fed to continue to fiddle with long term bond markets, mortgage rates, credit spreads, credit "availability" and perceived bubbles:

When establishing the longer-term goals and objectives for any organization, and particularly one that serves the public, it is important that the goals be achievable. Assigning unachievable goals to organizations is a recipe for failure. ...

...We have assigned an ever-expanding role for monetary policy, and we expect our central bank to solve all manner of economic woes for which it is ill-suited to address. We need to better align the expectations of monetary policy with what it is actually capable of achieving.

...Even though the [Fed's] 2012 statement of objectives acknowledged that it is inappropriate to set a fixed goal for employment and that maximum employment is influenced by many factors, the FOMC’s recent policy statements have increasingly given the impression that it wants to achieve an employment goal as quickly as possible.

What should the Fed do?

I have concluded that it would be appropriate to redefine the Fed’s monetary policy goals to focus solely, or at least primarily, on price stability.

The speech is very thoughtful about independence. In a democracy, an agency can only be independent if it has limited powers. An agency that writes checks to voters, allocates credit to favored businesses and industries, cannot be politically independent.

The current deal for independence is written in part in the Federal Reserve act which sets up the current "dual mandate," but

The act doesn’t talk about managing short-term credit allocation across sectors; it doesn’t mention inflating housing prices or other asset prices. It also doesn’t mention reducing short-term fluctuations in employment.

You're getting a sense of what genies Charlie would like to put back in their bottles. It's a bit remarkable for a Fed president to essentially say that Fed policy is not only unwise, but stretching the Fed's legal authority.  Yet independence is a good thing:

Even with a narrow mandate to focus on price stability, the institution must be well designed if it is to be successful. To meet even this narrow mandate, the central bank must have a fair amount of independence from the political process so that it can set policy for the long run without the pressure to print money as a substitute for tough fiscal choices

Such independence in a democracy also necessitates that the central bank remain accountable. Its activities also need to be constrained in a manner that limits its discretionary authority. 

... in exchange for such independence, the central bank should be constrained from conducting fiscal policy... [yet] the Fed has ventured into the realm of fiscal policy by its purchase programs of assets that target specific industries and individual firms.

What would Charlie do to draw some lines in the sand? One, by reinstating traditional limits on what assets the Fed can buy:

One way to circumscribe the range of activities a central bank can undertake is to limit the assets it can buy and hold. My preference would be to limit Fed purchases to Treasury securities and return the Fed’s balance sheet to an all-Treasury portfolio. This would limit the ability of the Fed to engage in credit policies that target specific industries.

Rules are important,

A third way to constrain central bank actions is to direct the monetary authority to conduct policy in a systematic, rule-like manner. It is often difficult for policymakers to choose a systematic rule-like approach that would tie their hands and thus limit their discretionary authority.  

And for more reasons than usual: if the bank is following a rule, it's much less open to political criticism and able to preserve its independence:

Systematic policy can also help preserve a central bank’s independence. When the public has a better understanding of policymakers’ intentions, it is able to hold the central bank more accountable for its actions. And the rule-like behavior helps to keep policy focused on the central bank’s objectives, limiting discretionary actions that may wander toward other agendas and goals

...assigning multiple objectives for the central bank opens the door to highly discretionary policies, which can be justified by shifting the focus or rationale for action from goal to goal.

Charlie agrees: you can't have effective forward guidance without precommitment, and you can't have precommitment and discretion. Here is the slam at how taper talk roiled bond markets

My sense is that the recent difficulty the Fed has faced in trying to offer clear and transparent guidance on its current and future policy path stems from the fact that policymakers still desire to maintain discretion in setting monetary policy. Effective forward guidance, however, requires commitment to behave in a particular way in the future. But discretion is the antithesis of commitment and undermines the effectiveness of forward guidance. Given this tension, few should be surprised that the Fed has struggled with its communications.

In some sense, arguing about the dual mandate is the last war. The Fed is now the Gargantuan Financial Regulator, and the "mandate" includes "financial stability," and detailed discretionary direction of credit flows. Charlie:

Some have even called for an expansion of the monetary policy mandate to include an explicit goal for financial stability. I think this would be a mistake.

The Fed plays an important role as the lender of last resort.... the role of lender of last resort is not to prop up insolvent institutions. However, in some cases during the crisis, the Fed played a role in the resolution of particular insolvent firms that were deemed systemically important financial firms. .. by taking these actions, the Fed has created expectations — perhaps unrealistic ones — about what the Fed can and should do to combat financial instability.

In fact, the bigger the fire house, the more the chance of fires:

I can think of three ways in which central bank policies can increase the risks of financial instability. First, by rescuing firms or creating the expectation that creditors will be rescued, policymakers either implicitly or explicitly create moral hazard and excessive risking-taking by financial firms. For this moral hazard to exist, it doesn’t matter if the taxpayer or the private sector provides the funds. What matters is that creditors are protected, in part, if not entirely.

Second, by running credit policies, such as buying huge volumes of mortgage-backed securities that distort market signals or the allocation of capital, policymakers can sow the seeds of financial instability because of the distortions that they create, which in time must be corrected.

I would add, if you prop up prices in bad times, you kill the incentive for people to keep some cash around to buy in the next "fire sale."

And third, by taking a highly discretionary approach to monetary policy, policymakers increase the risks of financial instability by making monetary policy uncertain. Such uncertainty can lead markets to make unwise investment decisions — witness the complaints of those who took positions expecting the Fed to follow through with the taper decision in September of this year.

"You can keep your bonds if you like them?"

The whole speech is good, I hope my excerpts get you to go to the real thing.