The Federal Reserve's Report Card

The headline reads “Conservative Republicans Propose to Pare Back Federal Reserve’s Dual Role.” (See www.nytimes.com/2010/11/17/business/economy/17fed.html?_r=1&ref=todayspaper.)

The Federal Reserve has been given two policy goals in the last half of the 20th century. The first policy goal given the Fed, the goal of full employment, was enacted into law in 1946. This act was called “The Employment Act” and it mandated that the federal government do everything in its authority to achieve full employment, which was established as a right guaranteed to the American people. This was supplemented in 1978 by “The Full Employment and Balanced Growth Act” also called the Humphrey-Hawkins Full Employment Act which encouraged the federal government to pursue “maximum employment, production, and purchasing power”.

The inclusion of “purchasing power” introduced into government legislation the goal of maintaining stable prices, the second policy goal for which the Federal Reserve is responsible for.

The concern of the Conservatives regarding the “Dual Role” can be expressed in thoughts coming from the economist Milton Friedman. First, monetary policy does not determine the level of employment in the economy in the longer run. Second, inflation is everywhere and at every time a monetary phenomenon. So, to these Conservatives, the Fed cannot achieve full employment and the attempt to achieve full employment by monetary means just results in inflation.

Is there any way we can measure the success of the Federal Reserve in achieving the goals connected with its “Dual Role”? Do the Conservatives have any case for the stance they are taking?

I believe there is a report card related to Federal Reserve actions and that report card is the foreign exchange market. This belief is expressed by Paul Volker, former Chairman of the Board of Governors of the Federal Reserve System. He has written, “a nation’s exchange rate is the single most important price in its economy…” This quote can be found on page 232 of the book co-authored by Volker and Toyoo Gyohten, formerly of the Japanese Ministry of Finance, titled “Changing Fortunes.”

Volker goes on to say that “what the Fed does in regulating U. S. money and credit inevitably affects exchange rates, and even the world money supply. Domestic and international (monetary policy), it’s a seamless web…”

And, what grade is given to the United States in the foreign exchange market?

The grade is derived from the chart below.

The value of the United States dollar against major currencies has declined by 33% from January 1973 to October 2010. It has declined by 35% at the low point in the chart attained in April 2008, just before the financial collapse which came in September 2008.

There are two breaks in the decline. The first begins in the late 1970s as President Carter was forced to bring Paul Volker in as the Chairman of the Fed which was followed by a very severe tightening of monetary policy. Market participants gave Volker high praise. Note, however, that the value of the dollar has declined by 51% from its peak, reached in March 1985, to its low point in September 2008.

The second break came in the 1990s as Secretary of the Treasury Robert Rubin, under President Clinton, moved the government’s fiscal budget into surplus range accompanied by a relatively benign monetary policy. The effect of the surplus caused the value of the dollar to peak in February 2002 as the Bush tax cuts and military expenditures became a reality. From this peak, the value of the dollar declined by 37% from the peak to the low point achieved in September 2008.

The two peaks after September 2008 came from the “flight to (credit) quality” accompaning the subsequent world wide financial crisis and in early 2010 by the European Union sovereign debt crisis. The downward trend in the value of the dollar always seems to continue after these “short-run” crises.

The best grade that I can give the Federal Reserve from this long-term behavior is a D!

World financial markets do not seem to support the execution of the Feds “Dual Role”!

One further note: the Federal Reserve is supposed to be independent of the administrative and legislative branches of government. However, the legislation of 1946 and 1978 took away that independence, if it ever existed. The first evidence of this is the fact that the United States floated the value of its currency in 1971 as a result of the inflation that was growing in its economy. This is why the chart only begins in 1973, because the value of the dollar was fixed internationally before this time.

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