It’s Time to End the Fed’s Dual Mandate

The Fed’s extraordinary, unnecessary, and irresponsible actions following the novel coronavirus outbreak should make us rethink its mission. Officially, the Fed’s mandate is to “promote effectively the goals of maximum employment, stable prices, and moderate long term interest rates.” This is known as the dual mandate, and it dates to a 1977 act of Congress. (Did you notice there are three goals there, not two? As it turns out, the “moderate long term interest rates” part of the mandate has fallen by the wayside, for good reasons.) 

Unofficially, because of the difficulties of achieving multiple goals, the Fed in recent decades has prioritized stable prices. However, thanks in part to buck-passing on the part of Congress, the consensus as to what constitutes responsible central bank policy has been turned on its head. 

In passing the CARES Act, Congress instructed the Fed to make loans directly to small- and medium-sized businesses, as well as state and municipal governments. These activities are supposedly justified under Section 13(3) of the Federal Reserve Act. In reality, they stretch the meaning of the Fed’s emergency loan powers to the point where there are minimal, if any, constraints on this power. The scope of the Fed’s actions in response to coronavirus have pushed us into terra incognita, as far as monetary policy goes. We will be wrestling with the problems created by the sheer size of the Fed’s balance sheet, as well as its expanded mandate, for years to come.

But it doesn’t have to be this way. Congress has modified the Federal Reserve Act many times throughout the Fed’s history. Congress can do so again. Perhaps the darkest hours of the coronavirus emergency were not the time for such discussions. But those times are waning. 

Unless we want to be stuck with an ultra-activist central bank, which engages in direct credit allocation and is more susceptible than ever to political pressure, we must demand Congress again set a new direction for the Fed. Specifically, Congress should direct the Fed to focus on a specific nominal anchor, such as NGDP growth or inflation. Any and all real variables should be outside the Fed’s purview, except as far as the Fed hitting its nominal target affects these variables in the short run. 

An excellent overview of the problems with the dual mandate, as well as why the Fed (and all central banks) should stick to traditional monetary policy, was penned during the 2007-8 financial crisis, between the Bear Stearns bailout in March and the Lehman failure in September. The authors are Anna Schwartz, one of the eminent monetary economists of the 20^th century, and Walker Todd, a former lawyer at the Federal Reserve Bank of Cleveland. Their argument is simple: central banks are good at controlling the monetary base in the service of hitting a nominal anchor, and bad at everything else.

Schwartz and Todd offer some lessons for monetary economists and central bankers. Here is one that stands out in light of what the Fed’s been up to:

“For the Fed to lend directly to the Treasury, to government agencies, or even to private entities that the Treasury otherwise would have to fund through the regular congressional appropriations process, is a slippery slope. The costs of doing so are politicization of the money supply process. As a general principle, the Fed’s charter wisely prohibits such lending. Discount window accommodations to insolvent institutions, whether banks or non-banks, misallocate resources. Political decisions in those cases are substituted for market decisions. Institutions that have failed the market test of viability should not be supported by the Fed’s monetary issues, and the Fed’s discount window lending expands banking reserves just as much as open-market operations do.”

Schwartz and Todd focus on potential abuses of discount window lending, because when they wrote, that was the largest risk. Hindsight has proven them right: Fed policy in the wake of the 2007-8 crisis was inappropriate based on orthodox last-resort lending principles. In fact, given the incentive and information problems, we have reason to wonder whether the Fed can ever act as a nice, responsible, Bagehotian lender of last resort. However, their argument is also relevant to our current economic circumstances. 

Although the Fed’s post-coronavirus operations probably aren’t illegal given the CARES Act, they are nonetheless fraught with problems. There is no reason to think the Fed can allocate credit more efficiently than the market. If the assets it purchases turn out to be no good, taxpayers will be left holding the bag. And since credit allocation is fiscal policy, not monetary policy, there’s a big risk Congress will use this as precedent to turn the Fed into an agent for achieving, via monetary means, things that should be left to the democratic and deliberative arena of fiscal politics.

What does all of this have to do with the dual mandate? The answer is, all the Fed’s money mischief is possible because it is not restricted to a single mandate focused on nominal stability. Restrict the range, and you manage the mischief. 

“Those who would prefer that the Fed pursue more than one mandate (the core central banking mandate presumptively is price-level stability) aspire to a state of the world that is potentially admirable but, alas, can find no sustainable expression in the real world,” write Schwartz and Todd. “The Fed does not control real variables relevant to its statutory mandates: productivity, economic growth and the unemployment rate. These variables reflect the quality of the labour force, the entrepreneurial capacity of the business community, and the availability of venture capital.” 

Hence it is chimerical to expect the Fed to protect us from any and every potential source of economic harm. The more we ask the Fed to do, the more we increase its power in excess of its responsibility. And we all know how that turns out.

If central bankers could be trusted to stand firm on the proper limits of monetary policy, perhaps this would not be so dire. And occasionally, central bankers have. Ben Bernanke made it clear the Fed would take no part in the General Motors bailout. Janet Yellen nixed the idea of the Fed rescuing Puerto Rico. 

While both of these ex-Fed chairs can hardly be called models of restraint, they were nonetheless correct on these issues. Their prudence was highly commendable. Alas, Jerome Powell seems to lack this prudence. And now that the precedent is set, we know it is only a matter of time before the money printer gets fired up again, for completely mistaken reasons.

Given the panic caused by coronavirus in past months, and now the nationwide tumult over protests and riots, it is understandable that monetary policy and the Fed have not received much attention. But this must change, and change soon. The Fed cannot continue to maintain its efficacy and independence under the current operating framework. 

Simply put, it is not a stable equilibrium. Something has to give, and the most likely outcome is Congressional pressure on the Fed in the service of political, rather than economic, goals. The only thing that can head this danger off at the pass is a demand by the American people that their representatives end this political-economic arms race. 

For better or worse, the Fed is a creature of Congress. It must be Congress that reins it in. The American people can and must ask their representatives to end the dual mandate. It is time to refocus the Fed on what it is good at (aggregate demand stability) and away from what it is bad at (everything else). 

The choice before us is simple: a central bank that is highly restricted, and therefore effective and independent, or one that is dominated by short-run political concerns, and therefore incompetent and subservient. Only the former gets us market stability and economic growth. 

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