Flying Blind: The Federal Reserve's Experiment with Unobservables

During the last fifteen years the Fed has experimented with a variety of monetary targets, including reserve aggregates (borrowed and nonborrowed); monetary aggregates as measured by M1, M2, and even M3; prices, as measured by P-Star, price indexes, gold prices, and expected inflation; and a variety of interest rates, including real "equilibrium" interest rates; choosing a new target variable, therefore, was not a novel event. However, although some members of the Fed proclaim their newest targets to be linked to actual inflation, the most recent switch is disconcerting to many Fed observers because there is little or no theoretical or empirical evidence to support the use of these variables as targets. Moreover, experience with a variety of targets has cast doubt on the likelihood that a single variable can be found to be closely and reliably linked to future inflation. It is even less likely that such a variable, should it be found, would somehow be under the control and manipulation of the Federal Reserve. In their paper "Flying Blind: The Federal Reserve's Experiment with Unobservables," Dimitri B. Papadimitriou and L. Randall Wray contend not only that there is no reason to suppose that the Fed will discover a target variable whose control will yield stable prices, but that the Fed simply does not know how to achieve stable prices. They argue that economists lack sufficient information to calculate the costs of achieving stable prices in terms of unemployment and lost output. Therefore, the Federal Reserve ought to take a less active role in the economy.