Chairman Powell and The Fed’s Limits
Published in American Institute for Economic Research, RealClear Policy, and the Federalist Society.
Federal Reserve Chairman Jerome Powell has realistically assessed the limits of the Fed’s knowledge, models, and legislative mandate. Bravo! His candor is far superior to any “pretense of knowledge” displayed by central banks and is a sound warning of the mission creep to which their regulatory activities are tempted.
Speaking at the Stanford Business School in early April, Powell observed that “Of course, the outlook is still quite uncertain.” Indeed, inflation is looking worse than the Fed had hoped, long-term interest rates have backed up, and short-term rates may not fall from here, or may rise. No one knows, including the Fed. The financial and economic future is fundamentally and inherently uncertain. A better statement would have been, “Of course, the outlook is ALWAYS uncertain.”
The dismal record of central banks’ economic forecasts confirms that they not only do not, but cannot, know the financial future, or what the results of their own actions will be, or what future actions they may take. Powell, trained in law and on Wall Street instead of academic economics, seems admirably aware of this truth, a truth uncomfortable for those who wish to put their faith in central banks.
Powell has previously pointed out that the celebrated “r star” (r*) — the “neutral interest rate” — is a theoretical idea which can never be directly observed. Economic models depending on it must produce uncertain results. In trying to be guided by such an idea, Powell wittily suggested, “We are navigating by the stars under cloudy skies.” That is a really good line and deserves to go down with former Fed Chairman William McChesney Martin’s famous “take away the punchbowl” in central banking lore.
Central banks’ poor forecasting record reflects both the limitations of human minds, no matter how brilliant, educated, and informed, and also the interactive, recursive, complex, expectational, reflexive, non-predictable nature of financial reality itself, so very different from Newtonian physical systems. Economic and financial systems are not composed of mechanisms (although that is a favorite metaphor in economics) but have among their core dynamics competing minds.
From this recognition, we see why “the macro-economic discipline can be thought more-or-less as an evaluation of a constant stream of surprises,” as an acute financial observer recently wrote. Economists, he continued, of course including those employed by central banks, tend to build “models of how the world should work, rather than how it does. It is not surprising that macro-economic forecasts based on these models fail.” We may conclude, as Powell seems to suggest, that we should not be surprised by the continuing surprises.
It is essential not to attribute the forecasting failures of central banks to any lack of intelligence, educational credentials, good intentions, or computer power. These failures of the highly competent arise because of the fundamentally odd kind of reality created by the economic and financial interactions they are trying to forecast and manipulate.
Especially difficult is that all economics is political economics, all finance is political finance, and all central banking is political central banking. Politics is always stirring and dumping spices, and sometimes poison, into the economic stew, especially by starting and prolonging wars, which are the single most important financial events. Just now we have plenty of war to contend with.
What are the central bankers to do? A good place to start is intellectual realism about how genuinely cloudy the economic future is. As an ancient Roman concluded, “Res hominum tanta caligine volvi.” (“Human affairs are surrounded by so much fog!”)
Sticking to the Assigned Mission
Also in his Stanford speech, Chairman Powell cited two well-known goals assigned by Congress to the Fed: maximum employment and stable prices. Note that the second, as written in the Federal Reserve Act, is exactly as Powell stated: “stable prices” — not “stable inflation,” “low inflation,” “perpetual inflation at 2 percent,” or any other price target except “stable prices.” Obviously, the Fed has not achieved stable prices. Should it nevertheless take on additional issues not assigned by Congress?
Powell answered soundly: No. “We need to continually earn [our] grant of independence,” he said, “by sticking to our knitting.”
He continued in a paragraph well worth quoting at length:
To maintain the public’s trust, we also need to avoid ‘mission creep.’ Our nation faces many challenges, some of which directly or indirectly involve the economy. Fed policymakers are often pressed to take a position on issues that are arguably relevant to the economy but not within our mandate, such as particular tax and spending policies, immigration policy, and trade policy. Climate change is another current example. Policies to address climate change are the business of elected officials and those agencies they have charged with this responsibility. The Fed has received no such charge.
Very true, it hasn’t.
Thus, he said, “We are not, nor do we seek to be, climate policymakers.” Nor is the Fed, nor should it seek to be, a policymaker for illegal immigration, law enforcement, failing public schools, the bankrupt student loan fiasco, insolvent Social Security and Medicaid programs, or scores of other issues.
Powell’s general conclusion is excellent: “In short, doing our job well requires that we respect the limits of our mandate.” This is consistent with his sensible 2024 Senate testimony that the Fed cannot create a US central bank digital currency without Congressional authorization.
But when it comes to controlling Fed mission creep regarding climate change, Powell did leave himself a significant hedge that Congress should think about. This was: “We do, however, have a narrow role that relates to our responsibilities as a bank supervisor. The public will expect that the institutions we regulate and supervise will understand and be able to manage the material risks they face, which, over time, are likely to include climate-related risks.”
How narrow is “narrow”? Will Fed actions in this respect be mandate-disciplined? Or under a different Fed leadership, might they swell and create a gap in limits big enough to drive a (presumably electric) truck through? We know that out-of-control financial regulators can decide to act as legislatures on their own, such as in the notorious Operation Choke Point scandal. Political actors who cannot get the Congress to approve their notions have discovered that the banking system is indeed a choke point for anybody needing to make financial transactions — that is, everybody. The most dangerous thing about a central bank digital currency is that the Fed itself could become a monopoly choke point operator, the dark possibilities of which have already been demonstrated in China and Canada.
Congress should applaud Chairman Powell’s candor on uncertainty and strongly support his principle of operating the Fed within the limits of its mandate. But as Fed leadership and presidential administrations come and go, Congress should itself define, not leave up to the Fed, what “narrow” expansions of the Fed’s role are authorized, and what is beyond the limits.