Impacts of Proposed Changes in the Fed’s Mandate

A few weeks ago Paul Ryan and I wrote an article proposing changes in the Federal Reserve Act. One change would require the Fed to focus on “the single goal of long-run price stability within a clear framework of overall economic stability.” Since then some have argued that changing the dual mandate in this way would not have prevented the recent highly discretionary monetary policy, which, in my view, has on balance been counterproductive. For example, Greg Mankiw writes on his blog that “If the Fed’s mandate were different, monetary policy today might well be the same. That is, with inflation now below its target, the Fed could be pursuing QE2 even if it were operating under the proposed mono mandate.” Similarly, in today’s Wall Street Journal Marc Sumerlin writes that such a change would “actually be supportive of the Fed’s current program.”

But there are several reasons to believe that QE2 would not have happened had Fed officials not been able to refer to a dual mandate in the Federal Reserve Act as justification for the intervention. First consider this bit of emprical evidence: There have never been so many references to the dual mandate by Fed officials as in the past year or so. If the dual mandate was not a factor in justifying and embarking on QE2, then why did Fed officials find the need to refer to it so much as justification for QE2 in the past year? In contrast, during the 1980s and 1990s, Federal Reserve officials rarely referred to the dual mandate (even in the early 1980s when unemployment was higher than today), and when they did so it was to make the point that achieving the goal of price stability was the surest way for monetary policy to keep unemployment down. Now, as Paul Ryan and I put it, “Advocates of aggressive Fed interventions cite the ‘maximum employment’ aspect of the Fed’s dual mandate.”

What about the argument that an inflation rate below the Fed’s target is alone enough to rationalize the unorthodox QE2 policy? I do not agree with this because the current low interest rate policy without QE2 is what is appropriate to deal with inflation being below the target. For example, the Taylor rule says that the federal funds rate is where it is because inflation is below its target. In other words that low interest rate policy means that monetary policy is doing what it should be doing to combat “too low” inflation, without QE2. Moreover, I think it would have been much harder to drum up support for QE2 based solely on deflationary concerns. As the Bloomberg graph below on breakeven inflation (USGGBE10) shows, the dip in expected inflation was quite small in 2010 and an argument based on that alone would not have carried the day in my view.

I have long been in favor of the Fed setting a target for inflation but not for unemployment. Here is a paper I gave at the 1996 Jackson Hole conference which explains why. In brief, by trying to focus on unemployment the Fed has actually increased unemployment. That was true in the 1970s and it is true recently: If the Fed had not kept interest rates so low when inflation was rising and the economy was growing in the 2002-2005 period, then we would have avoided much of the boom and the bust which eventually caused the devastating increase in unemployment.

One source of disagreement in debates about the mandate (which I tried to clarify in the 1996 paper) is confusion over the difference between the Fed’s goals and what the Fed reacts to. These are two different things. In particular, Sumerlin’s assessment that the Fed should react to credit aggregates is not inconsistent with the proposed changes in the mandate. Just as cutting interest rates in a recession when GDP falls below potential is an essential part of achieving a price stability goal in the framework of economic stability, so may be raising interest rates in a credit boom. The key idea is for the Fed to have and to lay out a strategy to achieve its goal. The strategy could entail credit aggregates, but that is a debate about how to achieve the mandate, not about the mandate itself.

About John B. Taylor 117 Articles

Affiliation: Stanford University

John B. Taylor is the Mary and Robert Raymond Professor of Economics at Stanford University and the Bowen H. and Janice Arthur McCoy Senior Fellow at the Hoover Institution. He formerly served as the director of the Stanford Institute for Economic Policy Research, where he is now a senior fellow, and he was founding director of Stanford's Introductory Economics Center.

Taylor’s academic fields of expertise are macroeconomics, monetary economics, and international economics. He is known for his research on the foundations of modern monetary theory and policy, which has been applied by central banks and financial market analysts around the world. He has an active interest in public policy. Taylor is currently a member of the California Governor's Council of Economic Advisors, where he also previously served from 1996 to 1998. In the past, he served as senior economist on the President's Council of Economic Advisers from 1976 to 1977, as a member of the President's Council of Economic Advisers from 1989 to 1991. He was also a member of the Congressional Budget Office's Panel of Economic Advisers from 1995 to 2001.

For four years from 2001 to 2005, Taylor served as Under Secretary of Treasury for International Affairs where he was responsible for U.S. policies in international finance, which includes currency markets, trade in financial services, foreign investment, international debt and development, and oversight of the International Monetary Fund and the World Bank. He was also responsible for coordinating financial policy with the G-7 countries, was chair of the working party on international macroeconomics at the OECD, and was a member of the Board of the Overseas Private Investment Corporation. His book Global Financial Warriors: The Untold Story of International Finance in the Post-9/11 World chronicles his years as head of the international division at Treasury.

Taylor was awarded the Alexander Hamilton Award for his overall leadership in international finance at the U.S. Treasury. He was also awarded the Treasury Distinguished Service Award for designing and implementing the currency reforms in Iraq, and the Medal of the Republic of Uruguay for his work in resolving the 2002 financial crisis. In 2005, he was awarded the George P. Shultz Distinguished Public Service Award. Taylor has also won many teaching awards; he was awarded the Hoagland Prize for excellence in undergraduate teaching and the Rhodes Prize for his high teaching ratings in Stanford's introductory economics course. He also received a Guggenheim Fellowship for his research, and he is a fellow of the American Academy of Arts and Sciences and the Econometric Society; he formerly served as vice president of the American Economic Association.

Before joining the Stanford faculty in 1984, Taylor held positions as professor of economics at Princeton University and Columbia University. Taylor received a B.A. in economics summa cum laude from Princeton University in 1968 and a Ph.D. in economics from Stanford University in 1973.

Visit: John Taylor's Page, Blog

2 Comments on Impacts of Proposed Changes in the Fed’s Mandate

  1. Bernanke would be unable to follow the inflation mandate unless he changed operating procedures (from an interest rate monetary transmission mechanism to legal reserves). Why? Because Bernanke didn’t “ease” monetary policy when Bear Stern’s 2 hedge funds collapsed. He initiated “credit easing” (expanding the FED’s balance sheet), while continuing with the 29 consecutive months of policy “tightening” that began in Feb 2006.

    I.e., Bernanke was actually contracting aggregate monetary demand at the same time real output was contracting.

    Instead of fighting the economic downswing from the getgo, Bernanke waited until Lehman Brothers failed. Bernanke actually drove this country into a deep depression by himself.

    • I am unsure if your facts are right or maybe I’m misunderstanding your point. The facts are the fed lowered rates about a month after the Bear Stearn’s funds collapse and lower rates by about 300bps by the time Lehman collapsed. If that is inaction please explain.

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