Should the Fed have a dual mandate?

The U.S. Federal Reserve is tasked with watching inflation while keeping the economy growing. This dual mandate is a juggling act no mortal could manage successfully for long. The result has been a Fed which has largely erred on the side of growth over inflation, leading to a weak dollar and many an economic calamity.

Martin Hutchinson over at has penned a very thoughtful piece on this problem suggesting the Fed give up its dual mandate and turn to price stability as its sole mandate. Below are his thoughts. I welcome yours as well.

The Federal Reserve’s track record over its 95 years is not particularly distinguished. Indeed, one of its few moments of glory came during the 1979-87 chairmanship of Paul Volcker. During his tenure, the Fed succeeded in bringing inflation under control, providing a sound store of value for the United States economy. The president-elect should change the Fed’s structure and mandate it to take aim only at inflation, so as to force its future chiefs to act more like Mr. Volcker.

Other than the Volcker years, the central bank has largely lurched from one mistake to another. After a loose-money decade in the 1920s, it let the nation’s money supply collapse in 1930-32, a proximate cause of the Depression. Later, it overexpanded the money supply in 1965-79, leading to soaring inflation.

After 1995, the chairmen, Alan Greenspan and now Ben Bernanke, made the same mistake, expanding the money supply far faster than the rate of United States economic growth. This caused bubbles in stocks, real estate and commodities for which the world is now paying the price. The fear of recession may outweigh the fear of inflation right now. But the specter of deflation has arisen because of the collapse of bubbles originally inflated by overly loose monetary policy.

The Fed’s poor performance is no accident. Its founders’ fear of an over-mighty central bank caused them to create an excessively decentralized structure that hampered decision-making. Worse, since the Employment Act of 1946, as revised by the Humphrey-Hawkins Act of 1978, the Fed has had a dual — and structurally contradictory — mandate: fight inflation and preserve full employment.

Mr. Volcker succeeded in reining in monetary policy only because he was given a free hand after his predecessor, G. William Miller, let inflation run wild. It rose to double digits. The nation was wise to give that power to a man of sound views and steely determination. Mr. Volcker raised interest rates sharply in his “October massacre” of 1979. Inflation fell to 3.2 percent by 1983, from 13.3 percent in 1979 — at the cost of a deep recession and considerable political unpopularity.

The president-elect should change the Fed’s legal structure and mandate so that it will maintain monetary stability, even if a person of Mr. Volcker’s stature is not running it. The objective should be to force even the feeblest political appointee to keep broad monetary growth in line with the growth of the economy. That means raising interest rates as high as necessary to keep consumer and asset price inflation low.

How can the new occupant of the White House insert new backbone into central bankers? Start with the way the Fed works. The 1913 Federal Reserve Act gave the central bank a decision-making group in Washington but also saddled it with 12 regional banks, all of which at various points have their say. That makes it hard for the decentralized institution to make decisions — but easy for politicians to influence monetary policy by leaning on the chairman.

The West German Bundesbank Act of 1958 — pushed through by Konrad Adenauer, the disciplinarian chancellor, in a country with vivid memories of the Weimar Republic’s hyperinflation in 1923 — provides a better model. The Bundesbank — Germany’s former central bank — was controlled collectively by the German länder (the equivalent of states in America), a dispersion of power that made political meddling by any one entity almost impossible. But it was also a single entity, allowing it to be managed efficiently.

A new Fed statute might give collective control to the states, making the Fed more independent. Also, personal testimony to Congress by the Fed chairman should be the exception, not the rule. Federal politicians should normally rely on the written Fed reports used by the financial system.

The Bundesbank had a single overriding objective: to achieve and maintain stability in the general price level. A similar goal would help the Fed succeed in its second job as the country’s principal bank regulator, since monetary stability — and the minimization of bubbles in asset prices — would lead to more stability in the financial system.

With protection from political meddling, the Fed would find it easier to fulfill the new mandate, however unpopular the necessary steps might be. Since its anti-inflation goal would take away its ability to create money arbitrarily, the Fed could not blow financial bubbles. Even the most inflationist chairman would find his institution Volckerized.

To Treat the Fed as Volcker Did – Martin Hutchinson, NY Times

  1. Anonymous says

    Ed, I just signed up. This is a great site for getting real details about how far we have come to date with announced bank loss data.

    Question. Do you have a sense of how far we still have to go with more US banking write downs. I saw the subprime totals, but aren’t the ALT-A, option ARM, prime ARM outstanding mortgage totals much larger than sub-prime? Are these losses even being recognized yet, when resets are just beginning?

    I assume when you look at the losses spread through the banking, investment, insurance,pension systems, unrealized and yet to be marked to market losses have to be in the trillions; do you agree?

    Thanks Mike

  2. Edward Harrison says


    Thanks for signing up. You ask some questions we are all asking. If you look at the Bloomberg figures on writedowns, you see about $590 billion as of a month ago. Interestingly, Bloomberg has now taken to calling these writedowns “credit crisis” related instead of subprime as they have upped the total to nearly $700 billion in writedowns.

    Up until about a month ago, 90% of the writedowns were subprime U.S. related I would say. Starting with Lehman Brothers’ earnings call in September we started to see more Alt-A stuff coming on line. But, most of this stuff has not been written down.

    The figures have been concentrated in money center banks because of FAS 157 and marking to market but a lot of local and regional have hidden losses on their balance sheets.

    Going forward, I see a lot more losses coming from the Option ARM and ALT-A segment of things as the losses move to more prime categories in the US. I also see credit cards becoming a problem because they have been securtized and again FAS 157 will be a problem.

    Eventually, the Feds will suspend or amend FAS 157 because the problem will get a lot larger. When you talk about pension funds and the like, none of these losses are surfacing in the mainstream news. These are not included in the figures I am referencing.

    I think the severity of the problem is larger than many people realize because there are all sorts of interdependecies in markets that create a downward spiral (like bonds being downgraded to junk and being dumped by mutual funds).

    For now, we seem to be in semi-rally mode. Some catalyst will cause people to realize that the workout phase here will take a while.

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