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Trump is on the money on US Fed

LiveMint logoLiveMint 26-02-2017 Vivek Dehejia

As a candidate, Donald Trump made pronouncements on a number of economic issues that, legitimately, aroused the concern of economists and observers, especially as these related to a putative increase in trade protection. Now that he is US president, Trump continues to make protectionist noises, but, at least on the North American Free Trade Agreement (Nafta), he recently took a conciliatory tack with Canadian Prime Minister Justin Trudeau.

There is much less discussion on an equally important topic on which candidate Trump weighed in, monetary policy. Those who remember the second presidential debate will recall that Trump observed, to paraphrase and engage in a bit of exegesis, that the US Federal Reserve’s unconventional monetary policies (UMPs) had fuelled a “false” economy replete with distortions such as asset price bubbles and a consequent misallocation of resources. Now, while not universally shared, obviously, this position is entirely defensible and not out of the mainstream, and is one to which I am sympathetic. Indeed, even former Reserve Bank of India governor Raghuram Rajan has said as much, when accusing the US and other advanced economies of “competitive monetary easing,” during numerous speeches he gave while in office.

As readers of this column will be aware, there is a lively debate within international macroeconomics and finance on how serious are the distorting effects on the global economy of our current non-system of inflation-targeting national central banks tied together through flexible exchange rates. There is a related debate on whether classical inflation targeting, and, even more so, UMPs, represent sound policy. As I have argued myself in these pages, UMPs, which have brought interest rates down to zero and have hugely increased the balance sheets of advanced economy central banks, may well be a cure worse than the disease they intended to cure, and, what is more, a policy stance from which there is no credible exit.

All that is likely to change under President Trump. With a unique opportunity to appoint five or more members of the Fed board, including replacing the chair, Janet Yellen, and vice-chair for monetary policy, Stanley Fischer, when their terms expire, the new president has an historic opportunity to set his stamp on American monetary policy.

Some libertarian and conservative supporters and advisers of Trump have previously advocated a return to a commodity-backed currency, such as the gold standard which prevailed before the World War I and which, in modified form, was the basis for the global monetary order under Bretton Woods.

This may be a bridge too far from the current regime of a fiat currency whose quantity is determined endogenously by setting the policy rate to achieve a predetermined inflation target.

What may be within reach, instead, is the abandonment of discretion and the tying of monetary policy to a fixed rule: some version of a Taylor rule, for instance, which, in its simplest form, sets the policy rate as a linear function of the gap between the inflation rate and its target and also the gap between the actual level of output and its potential level, controlling for the real interest rate and, possibly, other variables.

This is not the place to rehearse the varied and boisterous academic debate on the merits, or otherwise, of the Taylor rule or of other rule-based approaches to monetary policy. What is most relevant for our purpose is the willingness to consider a departure from the doctrine, one might even say dogma, of discretionary monetary policy—albeit a policy which, in principle, has a rule-based objective (an inflation target) rather than a rule-based instrument (for instance, a Taylor rule).

The reality is that inflation targeting is not a perfect science, as even the best economic models cannot predict with any degree of accuracy the reaction of inflation to a change in the policy rate, given the long and variable lag in the monetary transmission mechanism. There is also the inherent difficulty that an inflation targeting regime is predicated upon credible estimates of the inflation expectations of the public, which, in emerging economies even more than advanced economies, may at times be more fiction than fact.

Inflation targeting might, at best, be described as science married to art, or, better yet, to divination.

Recall that the stance of monetary policy cannot be divorced from the exchange rate in a world of open capital markets—the famous “impossible trinity” of Nobel economist Robert Mundell. In particular, an ostensibly inflation targeting monetary policy can be bent towards exchange rate manipulation—exactly Rajan’s critique of the US Fed, and also the critique by some American observers of Chinese monetary and exchange rate conduct.

Economist Judy Shelton, who worked on Trump’s transition, has recently advocated, writing in The Wall Street Journal, the inclusion in trade agreements of provisions to prevent members from using currency manipulation to distort the pattern of comparative advantage. As Shelton writes, “The distortions induced by government intervention in the foreign-exchange market affect both trade and capital flows.”

Now, if he tackles this issue, President Trump may be right on the money.

Every fortnight, In The Margins explores the intersection of economics, politics and public policy to help cast light on current affairs. Read Vivek’s Mint columns at

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