Fed under pressure

The U.S. presidential election next year will be a referendum on the size and scope of government, including the power of the Fed. Voters and foreign holders of U.S. debt deserve a serious debate, not more political posturing. The United States faces significant fiscal imbalances and a depreciating currency. Taking a principled approach to policy is essential for the future of freedom and prosperity.

In the meantime, the Fed may decide to engage in QE3. That would be a mistake. Eventually, interest rates have to rise—and bond prices fall. China and other large holders of U.S. debt will be penalized, more so as the dollar weakens.

The Fed's dual mandate requires that both price stability and full employment be achieved. The problem is that the Fed is limited: It cannot permanently affect real variables. Increasing base money to spur job growth has not worked. If the Fed abolishes interest on excess reserves, those reserves could be lent out. That would increase nominal income but have little impact on long-run growth. If inflation expectations increase, interest rates would quickly rise and stagflation set in.

The challenge will be for the Fed to revert to a credible policy of long-run price stability and prevent wide swings in nominal income. But as long as fiscal policy drives monetary policy, and the Fed tries to allocate credit, both monetary and fiscal policy will fail. Congress needs to reconsider the dual mandate and recognize the limits of monetary policy. The stage will then be set for real reform.

The author is vice president for academic affairs and a China analyst with the Cato Institute in Washington, D.C.