Hoisington Quarterly Review and Outlook, Second Quarter 2017
The Fed’s Dual Mandate
“Dual mandate” is one of the most commonly used phrases in U.S. central banking. The current Chair of the Federal Reserve often mentions it in both speeches and testimony to Congress. Not surprisingly, this is an extremely hot topic in monetary economics, and execution of this mandate has profound significance.
The mandate originated in The Federal Reserve Reform Act of 1977. This legislation identified “the goals of maximum employment, stable prices and moderate long-term interest rates.” Ironically, these goals have come to be known as the Fed’s “dual mandate”, even though there are actually three goals. The manner in which the Fed operates in following these goals has had and will have dramatic effects on economic activity. In this report we consider:
- What is the causal link between the mandate and the Fed’s capacity to act in a counter-cyclical fashion?
- How has the dual mandate morphed into the Phillips Curve?
- What are the arguments for and against a Phillips Curve based approach for conducting monetary policy?
- What does empirical research reveal?
In view of the extreme over-indebtedness and other adverse initial conditions, what are the immediate consequences of using a Phillips Curve based dual mandate for the economy, the Fed and fixed income investors?
To achieve the goals of this mandate (maximum employment, stable prices and moderate long-term rates), the Fed will inevitably tighten for too long and by too much. This occurs because considerable time elapses between the implementation of the monetary actions designed to follow the mandate and when the impact of those actions take effect on broader business conditions. By waiting to recognize a definitive change in inflation and unemployment, monetary policy changes will be pro-, not counter-cyclical. The time difference between leading or causative measures like the money and reserve aggregates, on the one hand, and the economically lagging series of the unemployment rate and inflation, on the other hand, can easily be three years or longer.
This difference between the actions of the Fed and the reactions within the economy explains why the Fed historically has not begun easing cycles until the economy was either in, or on the cusp of, a recession. When the Fed takes action, relief is painfully slow in arriving. Importantly, the economic risks from adherence to this dual mandate are now much greater than historically due to the economy’s extreme over-indebtedness, poor demographics and a fragile global economy.
To demonstrate, suppose that in the fourth quarter of this year, unemployment turns significantly higher while the inflation rate decelerates from its already subdued pace. The downturn that the Fed would be witnessing in the fourth quarter could be reflecting policy actions all the way back to the fourth quarter of 2015 when they initiated the current tightening cycle. This cumulative evidence is reflected in the monetary and credit aggregates (Charts 1 and 2). This change in economic fortunes might cause the Fed to accelerate the rate of growth in the monetary base and lower the policy rate in order to stimulate money and credit growth. However, the monetary and credit aggregates might not respond to these first steps until 2019 or even 2020, thus putting the Fed three years or more out of sync with the needs of the economy, suggesting a prolonged period of severe underperformance.
Being out of step with the goals of a counter-cyclical monetary policy will arise as long as the Fed keys its decision-making on unemployment and inflation, rather than on maintaining financial stability, which focuses on the reserve, monetary and credit aggregates. Achieving such stability, however, is now much more difficult for the Fed than in the past. Until the economy became so heavily indebted, M2 was a consistent leading economic variable. Now M2 only leads recessions. Until the debt overhang is corrected (which does not appear to be in the immediate future), the velocity of money is likely to continue declining. Thus, when the Fed eases in the future, the strong leading relationship between M2 and the economy will no longer prevail.
There have always been lags between the time of a policy shift and evidence of that shift in the broader economy. However, in a heavily indebted economy, with the velocity of money likely falling further, and policy rates close to the zero bound, the Fed’s current capabilities are decidedly asymmetric. Any easing actions taken now would be far less powerful than the steps taken in the prior tightening cycle. Thus, by keying off the dual mandate in an economy with a severe debt overhang, the Fed would be more disadvantaged than normal in trying to come to the quick aid of a faltering economy.