The Federal Reserve held their regularly scheduled meeting this week. As is always the case, they consider whether to increase or decrease the supply of money in circulation. This decision potentially affects inflation and nominal economic growth. Whatever the choice they will face criticism, so it is helpful to understand what, why and how they might take action.

The Federal Reserve was created in 1913 for a variety of reasons; none of which explicitly involve what we now call monetary policy. It wasn’t until the end of the Great Recession when economists began to consider how Fed actions might influence economic activity. But, it wasn’t until the 1960s that our current appreciation for the power of changing the money supply became well understood. Since then, our standard of living has more than tripled and the volatility of recessions dramatically lessened. This suggests more than passing benefits to monetary policy as it is now practiced. 

In 1947, Congress directed the Federal Reserve to keep both unemployment and inflation low. This is their dual mandate. Anyone with a semester of high school economics under their belt should immediately understand that these goals are in tension. Typically, low unemployment accompanies high inflation, while low inflation accompanies high unemployment. This requires monetary policy to make some informed judgements about appropriate action. As in any organization that employs a few hundred economists, this informed judgement involves an equation.

In recent years, the Fed appears to have used a version of the Taylor Rule to set short-term interest rates. These short-term interest rates are the most visible mechanism for influencing the money supply, so applying a clear formula to setting them reduces uncertainty about future rate changes. The Taylor rule is relatively simple. Translated into prose, it would suggest that interest rates should have two components. The first component would be set at some normal level, such as the inflation rate plus the inflation-adjusted historical interest rate. The second component accounts for the GDP and inflation gaps, or how much or little GDP growth and inflation are relative to where we should expect them to be. 

This is an easy equation, but it requires considerable effort to determine what the gaps in GDP and inflation might be, and there is rarely precise agreement on these estimates. Complicating the work of the Fed is the unavoidable fact that the newest data is never the most accurate. The most fundamental data points, such as the number of working adults, is subject to revision at least 18 months after the first estimates are delivered. The Fed does not enjoy the leisure to wait 18 months to slow inflation or boost a lagging economy. 

Of course, there are more tools available to alter the money supply than simply adjusting short-term borrowing rates. The Fed can buy or sell US bonds on the open market, which increases or decreases the supply of money in circulation. This has several affects designed to spur investment and growth, or to slow inflation. 

Over the years, the Fed has had many critics. Over the past few decades, academic economists informed a significant amount of Fed action, and the list of Nobel laureates whose work influenced monetary policy is lengthy. As a didactic took, I’d summarize these critiques into two camps. The first lies in improving methods, such as the Taylor Rule (a leading candidate for a Nobel). The second lies in uncovering some missed effect of monetary actions, such as the work of Milton Friedman and Anna Schwartz, or George Selgin today. Much of this work echoes Professor Hayek’s observation that “the curious task of economics is to demonstrate to men how little they really know about what they imagine they can design."

Politicians also criticize the Fed in ways that I might charitably characterize as somewhat less cerebral. 

On this go around, the Fed’s decisions will be more difficult than usual. Using 12 regional forecasts, they will see growing differences between regions. The Midwest is clearly in the beginnings of a recession. This cause of this is a trade war that is pushing up prices for manufactured goods. It remains to be seen if the rest of the nation will join us in that slump. Inevitably, in such an environment, few will be happy with the Fed’s decision. That might be the best sign they are doing their jobs.