Richard Alford: The Fed’s Dual Mandate – “Pirate Code” or “Alice in Wonderland”?

Yves here. Richard Alford makes an important observation in this post, but I beg to differ with his conclusion. In keeping with typical practice among economists, Alford makes a case against the Fed in a less direct manner than in the political press. Here, he discusses how Fed officials in their public statements on what its dual mandate means in practice have so often shifted ground as to render the term close to meaningless. However, surprisingly, he says he doesn’t have a problem with that because Congress and the Executive branch chose to cede ground to the Fed, and he argues that the Fed needs not to be subject to hard rules.

However, there is a world of difference between the central bank being put on a short leash by Congress and in letting it exercise as much power as it has over banking regulations and monetary policy with virtually no real oversight, particularly in light of what a terrible job it has done for everyone outside the banksters and the 0.1%. As we and others have discussed at length, the Fed’s mission creep has also encourage the central bank to use monetary policy to try to remedy the lack of sufficient fiscal spending. The results, as we know all too well, have been low growth, greater income inequality, and undue risk taking by banks and investors. So there’s a world of difference between putting the Fed on a shorter leash and putting it on a choke chain, and I suspect most readers would vote in favor of the former option.

By Richard Alford, a former New York Fed economist. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side

There is a parallel between the Fed’s dual mandate and the “pirate code”, but we need to cover some background first.

Does the Fed’s dual mandate require that the Fed pursue sustainable growth? Many Fed Governors and other Fed officials have defined the mandate to include sustainability, meaning durable growth. In a speech in 2007, then Governor Mishkin made the case for sustainability being both implied and important:

…Partly for these reasons, Federal Reserve officials and other policymakers often refer to this aspect of the dual mandate as the goal of maximum sustainable employment, and they place particular emphasis on the word sustainable.

He went on to say:

…In other cases, a tightening of the stance of monetary policy is needed to prevent…a boom bust cycle in the level of employment…

In a recent speech, Fed Vice Chairman Fischer used the word “sustainable” in connection with the dual mandate:

In particular, the Federal Reserve’s objectives are given by its dual mandate to pursue maximum sustainable employment and price stability, and our policy decisions are target to achieve these dual goals.

At others times, the word “sustainable” is absent. For example, Chair Yellen has also spoken on the Fed’s dual mandate:

The Federal Reserve’s monetary policy objective is to foster maximum employment and price stability.

In another recent speech, Yellen suggests that governments must adjust policies to address long-term issues, specifically structural fiscal deficits, but says nothing about the responsibility of central banks to promote sustainable growth:

What lessons can we draw from the experience? The first is that governments need to address longer-term challenges and significantly improve structural deficits….

The omission suggests that Yellen doesn’t see a role for monetary policy in promoting economic sustainability beyond achieving full employment and price stability in the short term.

Recently, Governor Brainard, has stated that the Fed has a “responsibility for safeguarding the stability of the financial system.” She went on to say that monetary policy has a role to play in a second line of defense, regulation being the first, against financial instability. After having ignored any role in financial stability in the run up to the crisis, numerous other Fed officials have now taken the position that financial stability is the province of regulation alone.

If we turn to the legislation in which the Fed’s mandate appears, i.e., the Federal Reserve Act as amended in 1977, it turns out that the word “sustainable” does not appear in the stated objectives of monetary policy:

“
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.

Five observations:

1. There is no mention of sustainability or financial stability, but the first part of the very long sentence that contains the mandate suggests that the long-run was more important to the drafters than the short-run, and hence sustainability is implied in the mandate.

2. The mandate lost the goal of “moderate long-term interest rates” very early in its history. Fed officials have argued that achieving moderate long-term interest rates will be realized if stable prices are achieved. Consequently, they assert the third leg is redundant and can be ignored. Hence the advent of the dual mandate. Question: Given the level of interest rates, are the QEs consistent with this neglected part of the mandate?

3. During the Bernanke era and possibly earlier, Fed officials made an additional parallel argument: Given the “natural rate of unemployment”, Fed policy could only affect the inflation rate and not the unemployment rate in the long-run. Hence, the full employment aspect of the mandate could be ignored, safe in the knowledge that it will be achieved in the long run as the result of price stability. The dual mandate had become a single mandate: inflation-only targeting. Of course, this line of argument buttresses the position that the mandate implicitly directs the Fed to promote full unemployment and price stability in the long run, i.e., sustainablility.

4. The dual mandate was reintroduced when unemployment spiked during the Great Recession.

5. In short, the Fed turned a tri-partite mandate into the dual mandate and later reduced it to a single mandate. And most recently, the Fed reverted back to a dual mandate.

Since 1977, the mandate has instructed the Fed to maintain growth in monetary and credit aggregates commensurate with the economy’s long-run potential, yet the Fed’s focus on the monetary and credit aggregates has been anything but constant. In 1975, the Fed had already announced targets for the growth of monetary aggregates in response to an earlier Congressional resolution. In 1979, the Fed publicly adopted non-borrowed reserve targeting to reinforce the perception of its commitment to hitting its monetary targets. The Fed was not successful in hitting the targeted rates of growth of the monetary aggregates, and some have questioned whether the Fed was really targeting the monetary aggregates. A number of students of the period have argued that the Fed replaced its interest rate target with non-borrowed reserves not in order to achieve better control of the growth of the monetary aggregates, but rather to:

• Establish a clear break with policies that had led to the unacceptably high level of inflation and to allow for expectations to adjust more quickly,

• Avoid problems and costs associated with searching for level of short-term rates that would achieve the desired reduction in the inflation rate, and

• Allow the Fed to respond to Congressional critics, who cited the level of interest rates, by saying that it was doing what Congress had instructed it to do.

Furthermore, former Fed Governor Mishkin noted in 2000 that:

The Fed also pursed other objectives during the monetary targeting period such as the exchange rate and financial market stability.

In late 1982, the Fed began to deemphasize the monetary targets as financial innovation broke down the relationship between the monetary aggregates, on the one hand, and GDP and the inflation rate on the other. In 1987, the Fed announced that it would no longer target M1-the narrowest measure of the money supply and the aggregate over which the Fed had the most control. In July of 1993, the Fed announced that it would no longer use monetary targeting.

Hence, it has been quite some time — about 30 years — since the Fed formally targeted any measure of the money supply or credit aggregate, if it ever did. Since the adoption of a Taylor Rule as a guide, Fed policy has been completely divorced from the growth rate of any measure of the money supply or credit. All this occurred while the sentence containing the dual mandate specified that the BOG and FOMC should maintain monetary and credit aggregate growth in line with the growth in potential output.

Given all of the above, it is apparent that Fed officials have treated the Fed’s legal mandate in a manner similar to the way the pirates of “The Pirates of the Caribbean” treated the pirate code—more a set of loose guidelines than a set of rules to be followed.

Or, one could argue that the Fed’s attitude towards its mandate is closer to the attitude that Lewis Carroll’s Humpty Dumpty had toward words, as revealed in this exchange with Alice:

“When I use a word,” Humpty Dumpty said in a rather scornful tone, “it means just what I choose it to mean – neither more nor less.”

“The question is,” said Alice, “whether you can make words mean so many different things.”

“The question is,” said Humpty Dumpty, “which is to be master—that’s all.”

Shakespeare also provided yet another possible description of the Fed’s record in regard to its mandate:”More honored in breach than the observance.”

Where does this leave us? The Fed?

I normally strongly disapprove of individuals and corporations ignoring or breaking the law. I normally hold government agencies to a higher standard, but in this case, the Fed’s multiple interpretations of its mandate does not have me up in arms. Why?

It has been 20+ years since the Fed publicly announced that it would no longer target monetary and credit aggregates. Neither the Congress nor the White House has ever objected and Greenspan was held in very high esteem in Washington post the announcement that the Fed would ignore that aspect of its mandate. Why probably because Congress and the White House have come to believe monetary targeting would be inappropriate and they cannot be bothered with changing the law. If for at least 20+ years, Congress and the Executive branches have behaved as if the law is best ignored, why should I be troubled when the Fed ignores the law?

Furthermore, the economic and financial climate can evolve rapidly. The Fed’s procedures and intermediate targets must be allowed to evolve along with the economy and markets so long as the ultimate targets, sustained full employment with price stability, remain unchanged. By no means do I agree with every change in policy or procedures that the Fed has made since 1977. Far from it, but if every change in Fed operating procedure or intermediate target had to have been OK’d via legislation, economic outcomes could have been far worse.

The Fed’s current adherence to the dual mandate raises problems. One can agree or disagree with the Fed’s position that monetary policy should never be used to promote financial stability. One may agree or disagree with the position that the Fed should only be concerned with economic performance in the coming 8 quarters (the Fed forecast horizon).

However, it flies in the face of history to argue that the Fed has been and is constrained by a narrow, inflexible interpretation of its legal mandate. Hence it is intellectually dishonest for the Fed to present the “dual mandate” as sacrosanct and inviolable. Given the history, especially post-2007, it is also hypocritical for the Fed to assert that it is above interpreting the law very loosely.

It is also inconsistent with the Fed’s emphasis on transparency for it to argue that policy choices have been and are constrained by the dual mandate. The Fed is simply using the “dual mandate” mantra as a means to deflect criticism and avoid debating if and when the Fed should use monetary policy to achieve sustainable growth via promoting financial stability and sustainable patterns of demand.

The Fed will only be able to achieve its ultimate targets, sustained full employment and price stability, if policy is free to evolve along with changes in the economic climate, both domestic and international, as well as changes in financial institutions, instruments and markets. The imposition of a hard and fast rule limiting policy flexibility, be it self-imposed or mandated by Congress, would at some point prolong adherence to inappropriate policy—if it has not already.