TIME TO REVAMP THE FED´S FLAWED MANDATE / THE FINANCIAL TIMES COMMENTARY & ANALYSIS COMMENTARY & ANALYSIS ( VERY HIGHLY RECOMMENDED READING )

Time to revamp the Fed’s flawed mandate

By Stephen Roach

Published: November 22 2010 18:53

The Federal Reserve’s grand experiment is a flop. Not only has the second round of quantitative easing roiled markets, but it has become a lightning rod for debate in Washington, academia, and in policy and political circles around the world. The US central bank’s uncharacteristic defensiveness has only deepened the suspicion – putting over 30 years of hard-won credibility and independence at risk. Sadly, this backlash is well founded. The Fed is running a real risk of destabilising a still precarious post-crisis world.


Unable to cut the price of overnight money any further, America’s monetary authority has turned, instead, to the quantity dimension of its arsenal. While the efficacy of this approach is debatable for a US economy in the throes of a protracted deleveraging, a deeper question arises when probing the Fed’s motivation. Justification is offered in the form of a new buzz-phrase – “mandate-deficient” growth.


In layman’s terms, this means that a post-crisis US economy is falling short of the Fed’s legally stipulated policy goals – full employment and price stability. That is especially true of a 9.6 per cent unemployment rate – to say nothing of the 17 per cent of America’s workforce that is either jobless or under-employed. But it is now also the case with a “market-based” core consumption inflation rate of 0.9 per cent that has edged below the threshold the Fed believes is consistent with price stability.


Consequently, out of basis points and true to its dual mandate, the central bank has shifted from conventional to unconventional easing. For Ben Bernanke, the Fed chairman, it is simply using a different, albeit non-traditional, technique to accomplish its objectives. So what’s the big deal?


The big deal is that the dual mandate itself is deeply flawed. For starters, it is a relic from a distant past. In 1978, after enactment of the Humphrey-Hawkins Act, the central bank was required to add price stability to its original charge of maintaining full employment as dictated by the Full Employment Act of 1946.


This arrangement worked reasonably well for about 20 years. But then, beginning in the late 1990s as the US approached the hallowed ground of price stability, the dual mandate led to trouble. Easy money, in conjunction with a central bank that was ideologically predisposed towards self-regulation, ushered in a dangerous bias toward excesses in asset and credit markets. The result was a bubble-dependent growth dynamic that eventually ended in tears.


Courtesy of QE2, those risks are back in play. The Fed chairman has been candid in laying out the game plan – underscoring the possibility that easier financial conditions in the form of a resurgence in stock and bond markets would lead to improved confidence and an impetus to aggregate demand inspired by so-called asset-based wealth effects. Sound familiar? It should. This is the same approach embraced by Mr Bernanke’s predecessor, Alan Greenspan.


The presumption is that QE2 will regenerate the animal spirits of America’s now dormant asset-dependent economy. But this hope is premised on a very dangerous strategy. Many, myself included, believe that it was precisely this approach that set the stage for the Great Crisis of 2008-09. The Fed insists it has the tools to avoid an inflationary outcome. That misses the point completely. This debate is not about tools – it is about the political will and independence to use those tools.


Nor is it just the US economy at risk here. The global implications are equally worrisome. Three considerations jump off the page:


First, let’s say Mr Bernanke is right and QE2 prompts an asset-market-led rebound of US consumer demand. Since asset-based economies tend to run lower income-based saving rates, America’s current account deficit would widen again – spelling renewed trouble for global imbalances.


The experience of 2004-07 is a case in point: bubble-driven personal consumption surged to a record 71.6 per cent of real gross domestic product and the personal saving rate plunged to a postwar record low of 1.2 per cent. Lacking in income-based saving, the US had to import surplus saving from abroad in order to grow – and ran massive current-account deficits to attract the foreign capital. To the extent that QE2 pushes the US down this same road, the Group of 20’s new-found rebalancing religion would be drawn into serious question.


Second, consider the perfectly reasonable possibility that the Fed is wrong and that US consumers continue to deleverage. In that case, the liquidity injection would not be absorbed by domestic demand. A significant portion of the QE2 could then leak offshore, sparking asset bubbles in high-return developing economies. This fear has already prompted a tightening of capital controls in South Korea, Thailand, Taiwan and China.


Third, QE2 is dollar negative. As such, it only exacerbates the skirmishes of the recent “currency war” – pushing the world all the closer to the slippery slope of competitive devaluations, trade frictions and protectionism. The China-bashing subtext of Mr Bernanke’s latest QE2 defence as presented on November 19 in Frankfurt only heightens these risks.


The only way to end this madness is to revamp the Fed’s dual mandate. What is desperately needed is a third leg to the stool – a financial stability mandate. If such a policy goal were hardwired into the Fed’s contract with the US Congress, the central bank would not have an excuse to ignore asset and credit bubbles as it has done repeatedly in recent years.


The dual mandate has outlived its usefulness. If Congress fails to address this flaw, we risk yet another treacherous endgame.


The writer, a member of the faculty of Yale University, is also non-executive chairman of Morgan Stanley Asia and author of ‘The Next Asia’


Copyright The Financial Times Limited 2010.