Sunday, November 27, 2011

Fed as thermostat?

"The Fed thinks they are playing with a thermostat - the house is too cool so we dial it up a little bit, now it's too warm, so we dial it down," Rickards said. "In reality, they are playing with a nuclear reactor. If you get it wrong, you're going to have a meltdown." - James Rickards author of Currency Wars  in NYTimes interview

Rickards, the author of Currency Wars, may be extreme but the idea that monetary policy is a thermostat has been applied to central banks for decades. The idea that the Fed could control interest rates was applied as optimal policy during the early 1970's. The result of research shows that lags, feedback and expectations make trying to control monetary policy difficult. The result was a movement first to monetarism through long-term control of the money supply and then to inflation targetting. We have now moved back to the idea that central banks should control the thermostat and this places a new, but actually old, burden on the central banks. Precise control of monetary policy is dangerous. Asset markets can actually see more volatility given this desire for control. 

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