Quote of the Day: Monetary Policy Cannot Solve All Economic Problems That May Ail Our Economies; What happens When The Fed Stops Distorting Prices?

The authority of monetary policymakers to intervene in financial markets has come to be accepted and expected. Whether the purpose is to change the relative price of various assets, such as long vs. short dated Treasuries, or to alter the allocation of credit, such as Treasuries vs. mortgage-backed securities, the result has been a much more interventionist central bank. The belief is, of course, that central bankers know enough to control relative asset prices with sufficient precision and that the transmission mechanisms and consequences are sufficiently predictable that policymakers can better control real economic growth and employment, and now, financial stability.

I find this a dubious proposition at best. For central banks to act as if these conditions exist suggests to the public that monetary policy has great ability to fine tune economic outcomes. That means monetary policy makers may well be accepting more responsibility for managing economic outcomes than they, in fact, can deliver. This is a recipe for failure and can undermine the public’s trust and confidence in the central bank. So maybe a little more humility on the part of central bankers and the public regarding what they monetary policy can accomplish is in order and a little less intervening just because it can, or has the power or authority, may be prudent. Monetary policy simply cannot solve all economic problems that may ail our economies.

(bold added)

This quote is from Charles Plosser former President, Federal Reserve Bank of Philadelphia and former Dean, Graduate School of Business Administration, University of Rochester as interviewed by the Money and Banking blog

More juicy quotes (bold mine)

As I mentioned, no regulatory authority anywhere in the world, no central bank no financial supervisory agency, saw the crisis coming. What makes us think we will spot the next one? Whenever it arises it will surely come from somewhere the authorities were not looking.

We face a number of challenges. First we have the problem of defining financial stability. I know of no good definition. Without a definition how do we know if we have succeeded? How do we know if we have over compensated and reduced risks too much without some metric that tells us of the trade-offs? Implicit in the Dodd-Frank legislation is the view that if only we could write enough rules and prohibitions on the financial sector we could solve the problem. I believe this is a bit like the dog chasing its tail, and equally futile.

Second we should acknowledge that stability risks can move around. Where regulators look, those risks are unlikely to be found. The challenge is figuring out where they will show up next. Financial markets are adept at packaging and repackaging risks in forms that the market will buy. There is nothing inherently wrong with this except regulators will always be behind the market developments.

Finally, the central bank should be particularly vigilant in not artificially encouraging financial imbalances or stability risks through its monetary policy actions. Unfortunately, this may bring financial stability and the goals of monetary policy into stark conflict. There is an ongoing and important debate on this issue. That is, should monetary policy be used to address financial stability risks or not; what if it’s a source of the risks?

Today the stated goal of the interventions undertaken by the Fed such as the asset purchases or the maturity extension program have been intended to encourage risking-taking and alter the portfolio balances of economic agents. If successful, these actions distort market prices. One stability risk worth considering is: What happens when the Fed stops distorting prices?

Wow! Ambiguity in the definition of financial stability, stability risk in a state of perpetual flux (or also policy or political response as 'fighting the last war' or dealing with past rather then present evolving problems) and most importantly, treating symptoms while encouraging the disease (financial imbalances) seem as an implied rebuke on central banking's "macroprudential policies" and the Basel Standard!