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The Federal Reserve has too many jobs to do all of them well.
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TheAgency (CJStumpf) | Creative Commons 3.0
We constantly hear of the “dual mandate” of the Federal Reserve to maximize employment and minimize inflation. Many experts question whether the central bank can achieve these two objectives at the same time. This question greatly oversimplifies the problem, for the Fed has not two mandates, but six.
The provision of the Federal Reserve Reform Act of 1977 that gives rise to the talk of the dual mandate actually assigns the Fed three mandates. It says that the Fed shall “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” That is obviously three goals — a triple mandate, at least.
Let’s consider how the central bank is doing at this triple mandate, before identifying the additional three goals.
Stable prices: This goal was in fact dropped long ago and is now a dead letter. The Fed’s stated goal is a relatively stable rate of increase in prices — 2% per year. More simply put: perpetual inflation, a steady depreciation of the currency it issues. At 2% inflation per year, average prices will quintuple in a normal lifetime. With a straight face, the Fed calls this “price stability.”
Maximum employment: When this goal was added to the governing statute in 1977, many people believed, as no one does now, that there is a simple-minded trade-off between inflation and employment. The Democratic sponsors of the bill may have believed it, but they were especially interested in not allowing the Fed to use controlling inflation as a reason for what they saw as insufficient monetary efforts for job creation. What they produced was the tangle of the triple mandate. In 1978, they added a wordy provision requiring the Federal Reserve to report to Congress on its plans and progress on the three goals. Such consultations obviously failed to avoid the financial crises of the 1980s, or the giant bubbles in tech stocks and housing of the 1990s and 2000s.
Moderate long-term interest rates: During the 1940s, as a servant of the Treasury, the Fed was a big buyer of long-term government bonds to finance World War II and suppress the cost of interest on the ballooning national debt. After the war, the Fed could continue to hold down interest rates; the question was whether it should. In 1951, the Fed and the Treasury agreed to end the purchases. In the ensuing years, the yield on 10-year Treasuries escalated from 2.5% in 1951 to a high of 15% in the early 1980s. Now the Fed is again a big bond buyer, having this time added the purchase of mortgage securities, in order to hold down interest rates on long-term government bonds and government-guaranteed mortgages. Again it has been a success at manipulating interest rates downward, and again its value is debatable. Rates came down to less than 2% on long-term government debt, which was zero or negative in real terms. That’s not a “moderate” interest rate.
Of far greater seniority and standing is the fourth mandate of the Fed, which stood first in the Federal Reserve Act in 1913. What did the legislative fathers of the central bank want to achieve? They told us clearly. The original act begins: “An Act to provide for the establishment of Federal reserve banks [and] to furnish an elastic currency.”
What We Really Have
In 1913, an elastic currency meant the ability to make loans from the central bank to expand credit and print money to match the economic exigencies of the moment, whether grounded in the agricultural seasons, the business cycle, or a financial panic. The Panic of 1907 strengthened the calls for an elastic currency. A century later, the ability to deliver it was practiced with great energy by the Fed in the panic of 2007-09, and is very much with us, under the moniker of “quantitative easing.”
As intended by the original Federal Reserve Act, an elastic currency is most definitely what we have gotten, not only in the U.S., but, given the global role of the dollar, in the world. That is one mandate fully achieved.
Banking expert Charles Goodhart has convincingly argued that most central banks have evolved to become managers of the banking club. As an early Fed plaque proclaimed, “The foundation of the Federal Reserve System is the co-operation and community of interest of the nation’s banks.” This is indeed the Fed’s fifth mandate, also a mandate fully achieved for the time being. The Dodd-Frank act has expanded its importance, making the Fed the manager of an even bigger financial club that includes nonbank financial firms, as well as banks.
The Greatest of Them All
Finally, we come to the most important and most basic Fed mandate of all: financing the government.
This is the longest tradition of central banking, found in pure form in the deal that created the Bank of England in 1694. The new bank got a monopoly to issue paper money; in exchange, it lent money to the government. Such central banks are exceptionally useful to governments. As economist Elga Bartsch has correctly written, “The feature that sets sovereign debt apart from other forms of debt is the unlimited recourse to the central bank.” This feature became evident very early in the history of the Fed. When the U.S. needed to finance its plunge into World War I, the Fed, as it reported about itself, “recognized its duty to cooperate unreservedly.” It did so again for World War II and for the undeclared wars that followed.
This sixth and greatest Fed mandate allows us to understand why the Fed, while not doing so well at stable prices, maximum employment, moderate long-term interest rates, or financial stability, nonetheless has gone on to ever-greater power and status.
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