Central Banks and Their Roles

Before the early 20th century, central banks’ responsibilities and thus their powers were rather limited. They were set up to issue currency, purchase government debt and facilitate inter-bank transactions. There were not many monetary policies to make; managing the macro economy was not their responsibility.

How the Fed comes into power

The widely held belief at that time was that the macro economy would correct itself by the force of the market. If the demand were weak, commodity prices would go down and bring back the consumption. If unemployment went up, the price for labor would decline and bring back the employment level. The nominal economy metrics, such as the GDP and the CPI should be uncoupled from the real outputs and consumption of the society as a whole.

However, the great depression in the early 20 century changed the prevailing view. People realized that the nominal economic factors really have a profound effect on the real economy factors. The market may not always be able to correct itself. Part of the reason is price rigidity. For example, if demand were low, firms may lower production instead of lowering price. Also if unemployment were high, people may still not be willing to work for a much lower wage. So if the equilibrium were out of whack due to some large shock to the economy, the market alone cannot recover the economy, at least not in a timely fashion. Some kind of coordinated intervention, such as policy change, is needed.

Thus the central banks, in particular the central bank (the Fed) of the United States took on a much bigger responsibility than before: To correct the market failures in the macro economy using monetary policies.The Fed has several levers, but they all boil down to interest rate manipulation. For example, if the inflation were high and the market cannot correct itself, the Fed will manipulate the interest rate to make it higher, so the firms are less likely to invest, thus bringing down the aggregated demand, and the price in the end. If unemployment were high, the Fed would lower the interest rate so firms have an easier access to capital so they can invest more and hire more people in the process, so unemployment would come down.

The Fed has two mandates, which are: one, controlling inflation, two, controlling the unemployment rate. The power to control the interest rate has great influence on the economy, so to prevent the power from being abused by the government for the agenda of the politicians, the Fed gained autonomy status from the government in the 1950s, so it can focus on it’s mandates without answering to the whim of public opinions or election cycles.

Fed's dilemma

However, the tool the Fed has, the interest rate, while powerful, is only in a single dimension. On the other hand, the crisis of the economy can be very different in nature and contains many variables; so sometimes the Fed is in a dilemma: On one side they want to lower the interest rate to fight unemployment, while at the same time they need a higher interest rate to combat inflation, such as in the “stagnation” case of the 70’s. We also need to consider that manipulating the interest rate can also have many side effects, some of them not prominent until several years later. For example the sub-prime crisis was largely caused by a prolonged low interest rate period after the recession in the early 2000’s.

There is another important factor we need to consider. The chairman and governors of the Fed are only human; they could make mistakes, or worse, they could have their own agenda to push, their own gains to chase. How do we make sure the Fed will always act in the interest of the whole society? How do we gauge the performance of the Fed, and correct the “correcting acts” of the Fed if something went haywire?

I don’t pretend that I even have the faintest idea for the answers to those questions. I think the Fed alone, with the weapon of adjusting the interest rate, cannot handle the newer generation of recessions. On the other hand, we probably don’t want to empower the Fed even further so they become gods. I see that there are two great powers that affect the economy: the fiscal policy wielded by the government, and the monetary policy wielded by the Fed. I believe there needs to be yet another power, separated from both the government and the Fed, to make the system robust. I don’t know what the power is though.