Sheer luck may allow you to kill two birds with one stone, but you should not count on it. The same is true in economic policy.
“You cannot accomplish two policy goals with only one policy instrument,” is how economists phrase it. Keep that in mind as the Federal Reserve’s Open-Market Committee meets this week.
A central bank has only one policy instrument: It can increase or decrease the money supply. That is it, period.
Changing the money supply affects other things, however. Abundant money lowers interest rates. Scarce money boosts them. That is the only way the Fed “controls” interest rates.
Changes in money supply also affect inflation. Fast money growth fosters inflation. Slow growth decreases it. Too-slow growth can cause deflation or falling general prices. Japan experienced this in the 1990s.
Money-supply changes can have short-run effects on national output and employment. If the economy is slack, faster money growth can boost output and the number of jobs. Constricting money growth can slow output and reduce employment.
Finally, money supply changes affect the value of the dollar compared to other currencies. Such changes in the value of the dollar in turn affect imports, exports, U.S. investment abroad and foreign investment here.
Many people, including politicians, expect the Fed to be able to knock a whole flock of birds to the ground with one stone. If the Fed just does its job, we will have low interest rates, low inflation, high GDP, low unemployment and a strong dollar, they believe. And, oh, yes, prices of corporate stocks and houses should remain high, too.
This is harmful self-delusion. The Fed can reliably manage the money supply to accomplish one objective, but no more than one. And the tradeoffs are harsh.
Constrict the money supply to choke off rampant inflation and the dollar may soar in value. That hurts exporters and anyone who has to compete with imports. That is how our steel, auto and farming sectors got hammered in the 1980s.
Tap the monetary brakes and then the gas to micromanage the business cycle? That is how the U.S., Canada, Britain and many other countries got “stagflation,” the worst of both worlds in the 1970s.
In the long run, the Fed cannot do anything directly to make the economy grow faster or to create more jobs. All it can do is maintain a relatively stable price level with little inflation or deflation.
But the Fed can achieve that goal only if citizens have realistic expectations about the capability of their central bank.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.