The Fed’s dual mandate and taking away the punch bowl

Editor’s note: A version of this post was originally published at my Patreon account on 13 Jun

Since the Fed is raising interest rates, it’s a good time to talk about how the Fed accomplishes its mission. The present model at the Fed is based on fine-tuning the economy versus a model I think is appropriate, centered around credit. Let’s call this a choice between the narrow dual mandate model versus the punch bowl Fed model. I’ll explain below.

The dual mandate

The dual mandate is a new thing – at least in Fed historical terms. The Fed began operations in 1913. And Congress didn’t institute the dual mandate until 1978. Here’s an article on the Fed website outlining what happened. It’s called “Full Employment and Balanced Growth Act of 1978 (Humphrey-Hawkins)“. Here are the important bits:

The Employment Act of 1946 stated that it is the responsibility of the federal government to create “conditions under which there will be afforded useful employment for those able, willing, and seeking work, and to promote maximum employment, production, and purchasing power.” In a 1976 hearing, Sen. Hubert Humphrey commented, “It is my judgment that that law has, from time to time, been conveniently ignored”. He wanted to adopt legislation that would enumerate more explicit employment goals, and if those goals were not met, to have the government provide jobs to achieve the target…

Humphrey died in January 1978, but later that year the Full Employment and Balanced Growth Act, better known as the Humphrey-Hawkins Act, amended the Employment Act of 1946 and was signed into law by President Carter. The Humphrey-Hawkins Act contained numerous objectives. Among them, unemployment should not exceed 3 percent for people 20 years or older, and inflation should be reduced to 3 percent or less, provided that its reduction would not interfere with the employment goal. And by 1988, the inflation rate should be zero, again provided that pursuing this goal would not interfere with the employment goal.

So the goal was to stop stagflation – high unemployment and high inflation. And Congress would do this by making the federal government, including the Fed, responsible for achieving employment and inflation goals.

There’s a lot more to the article. So if you’re a history buff, I suggest you read it.

Humphrey wanted the government to act on employment

Notice the part where it says Humphrey “wanted to adopt legislation that would enumerate more explicit employment goals, and if those goals were not met, to have the government provide jobs to achieve the target.” That’s the crux here in thinking about Fed policy.

What Humphrey was saying was that it was the government’s role to create the preconditions for full employment. And he felt that Congress had to direct the Fed, as a vehicle of government policy, to help get there. Humphrey wanted the legislative and executive branches to create full employment pre-conditions. The Fed was simply a foot soldier in that quest. You can see this when the article states:

“Humphrey also wished to give the executive branch a greater role in the execution of monetary policy: The president would submit his recommendations for monetary policy, and the Federal Reserve Board of Governors would have to respond within fifteen days to explain any proposed deviation. Neither proposal passed, but Humphrey and his colleague in the House, Augustus Hawkins, continued to push for similar legislation.”

The central bank is the government’s monetary agent

Personally, I am sceptical about having political operators ‘dictate’ monetary policy. And we know the Bank of England in the UK actually went the other direction, gaining greater independence in the mid-1990s. Even so, the important takeaway is that the central bank is an agent of government. It works at the behest of a sovereign government to achieve the monetary aims of that government. The only reason a central bank has broad-based independence is to prevent short-term political considerations from dictating the course of monetary policy. Its broader goals are the same as the rest of the government, led, of course, by the legislative (and, in the US, the executive) branch.

So the dual mandate is about making sure everyone is gainfully employed. That’s the “public purpose” of government. Government maintains an economic system that employs each and every individual citizen as productive members of society. Seeing mass unemployment and high inflation, Humphrey wanted the government to act. And he wanted the Fed as a part of that action. His goal was full employment – and to a lesser degree low inflation.

The anti-government interpretation of the dual mandate

Humphrey was an old-fashioned social democrat. And his ideas of government intervention were out of fashion. Ronald Reagan captured the Zeitgeist at his inauguration two years after Congress passed Humphrey-Hawkins when he said:

The economic ills we suffer have come upon us over several decades. They will not go away in days, weeks, or months, but they will go away. They will go away because we as Americans have the capacity now, as we’ve had in the past, to do whatever needs to be done to preserve this last and greatest bastion of freedom.

In this present crisis, government is not the solution to our problem; government is the problem. From time to time we’ve been tempted to believe that society has become too complex to be managed by self-rule, that government by an elite group is superior to government for, by, and of the people. Well, if no one among us is capable of governing himself, then who among us has the capacity to govern someone else? All of us together, in and out of government, must bear the burden. The solutions we seek must be equitable, with no one group singled out to pay a higher price.

The Fed as the only game in town

So, from that time forward, Congress would never dictate to the Fed. And the Fed would also assume the heavy lifting of the dual mandate. Full employment and low inflation gradually became the Fed’s responsibility much more than the legislative and executive branches. The role of Congress and the President was to “get out the way”. Their new goal was to allow business as much room to operate as possible to maximize output and growth. The Fed would ‘fine-tune’ the economic outcomes by dialing up or dialing down monetary stimulus to meet its dual mandate over the medium term.

This is why the Fed is so important. In effect, it’s the only game in town. Yes, Congress and the President can tax and spend, but only to set out a broad platform for growth. The nitty gritty of making that growth run over a business cycle falls to the Fed. And since the Fed’s chief monetary lever is interest rate policy, the change in interest rates dominates how we think about that cycle.

The Punch Bowl Fed model

Once upon a time, Fed policy wasn’t about fine tuning macro outcomes. It was about maintaining the safety, soundness and stability of our banking and credit system. That meant cutting rates when the economy was at a trough and credit was in short supply. But, crucially it also meant the Fed was “to take away the punch bowl just as the party gets going” as former Fed chair William McChesney Martin put it.

That’s all about the banking system, about credit. it’s not about inflation and full employment. And that model makes sense because interest rates are a credit lever. They are effectively the price of credit. And the Fed, as monopoly supplier of bank reserves, controls that lever on the short end of the yield curve.

So in the Punch Bowl Fed model, a bubble that allows loss-making companies like Uber or Tesla to be valued at tens of billions of dollars gets snuffed out before that happens. Financial institutions cut off credit to speculative and Ponzi creditors before they receive too much money. And the result is a downturn with much less damage.

Imagine a world in which the 2001 recession was met chiefly with Congressional action and less so with interest rate cuts. For example, imagine a larger Bush tax cut, a payroll tax cut, and infrastructure expenditure to cushion the downturn. Rates wouldn’t need to fall to 1%. The housing bubble wouldn’t have formed. And we wouldn’t have had a massive financial crisis. The over-reliance on the Fed to cut and restore growth is what caused the bubble. A more balanced policy mix would have avoided the worst excesses of that period.

We need more balanced macro policy

So as the Fed raises rates today, that’s what I will be thinking. As rates go up, the worry for most people is that the curve inverts and recession soon follows. And when that recession happens, a lot of the excess of this period gets wrung out in the downturn. Maybe we get another financial crisis as a result.

Back when the Fed’s mandate was taking the punch bowl away, we didn’t have financial crises every ten years. We need to move back to that economic model.