Monetary policy, in its current incarnation, is conducted by the Federal Reserve System of the United States. The semi-private nature of the Fed's governance and its responsibility in maintaining the value of a fiat currency have both prompted critics to call the institution's legitimacy into question.
Critiques of central banking are based on theories that point to the limitations central bodies confront when conducting monetary policy. Among such limits is the basic problem of being unable to quantify the amount of money circulating throughout the economy. Without that knowledge, it is impossible for the rate of inflation to accurately be calculated. Inflation can be calculated, with some accuracy, as the size of the money supply times its velocity.
The problem arises when trying to determine how to measure the supply of money, or know how fast it is changing hands. Friedrich Hayek's critique of central banking rested on the insight that money is not easily quantifiable because money is not easily definable. Money(or currency) is money, we all know that. But is gold money? Yes, for some people. What about six month CD's? Those are probably money to most people, because they guarantee payment in a short amount of time. Two year CD's, on the other hand, are less likely to be considered money. Those are just a few examples. Once you consider all of the bartering, mattress saving, and currency destruction that goes on in an entire economy, you see how enormous the task of central banking becomes.
So even if a central banker was somehow able to know the exact rate of inflation(or interest rates, for that matter) which should be targeted, he or she would still have to measure his progress using flawed data. This does not, however, imply that central banking should be abolished entirely. The idea that central bankers have limited knowledge implies, instead, that their role should be limited.
Rules-based monetary policies have been proposed as a way to rein in the excesses of central banking. Eminent proponents of such rules include John Taylor and Milton Friedman. Such rules replace discretion with an equation as a means of determining monetary policy. The knowledge problem in calculating, predicting, and modifying future inflation rates that I previously discussed will still be there, however.
A better system would seek to minimize the problem through competition. Competing banks and monetary institutions with the right incentives might provide market participants with a save haven against central bank policy failures. Moving toward such a system would not require radical changes. A huge difference could be made with small changes such as removing taxes on private banknotes, gold, silver, platinum and palladium. This would allow a market for private currencies to take hold, if they are found desirable.
We should not, however, neglect to deal with some of the Fed's worst excesses. A limited role for the Fed would make it, as with other market participants, stick to monetary policy without conducting ill-advised interventions. Thus, the Fed's role ought to be limited to its traditional duties, including: issuing currency, conducting open-market operations, acting as a lender-of-last-resort, and providing financial services. Simultaneously, the Fed's mandates to ensure moderate long-term interest rates and full employment ought to be repealed. The Fed should only be tasked with maintaining price stability. Also, the Fed should never be allowed to target inflation rates that are greater than targeted interest rates. This would effectively ban negative interest rates, which amount to nothing but free money to borrowers at the expense of everyone else.
Such modifications to monetary policy, while modest and incomplete, would make a difference. Rationalizing U.S. monetary policy is not a task which can be accomplished overnight, and would likely require some trial and error. Still, the enormous task of fine-tuning our complex monetary framework can't be started until its obvious stupidities are dealt with.
