THE FED´S DUAL MANDATE IS NOT THE PROBLEM / THE WALL STREET JOURNAL OP EDITORIAL ( HIGHLY RECOMMENDED READING )

OPINION

DECEMBER 28, 2010.

The Fed's Dual Mandate Is Not the Problem

The central bank's record on stable prices would not be any better even if it had no duty to promote maximum employment.

By MARC SUMERLIN

Greatly concerned about the Federal Reserve's quantitative easing program, many conservative members of Congress are actively talking about changing the central bank's dual legal mandate—keeping its mission to promote price stability but removing its requirement to promote maximum employment. With a single purpose, price stability, the thinking goes, the Fed will stop trying to tinker with employment and shift back to a sound-money policy.


Unfortunately, that plan would not have prevented the stock market or housing bubbles of the last decade and a half. And it would actually be supportive of the Fed's current program.


Recent history provides ample room for criticism of the Federal Reserve, but none of it is due to its employment mandate. Take first the Fed's complicity in the late 1990s bubble. From January 1995 to May 1999, it reduced interest rates to 4.75% from 6% even as real growth averaged 4% and the Nasdaq climbed from 750 to 2500.


What gave the Fed comfort to reduce rates during the biggest boom in U.S. history? Falling inflation. By its preferred measure—changes in the prices of personal consumption expenditures excluding food and energy (core PCE)—inflation dipped to under 1.5% from 2.5%. The central bank did finally raise interest rates in June 1999. Yet if the Fed only had an employment mandate it would have started to raise interest rates a full two years earlier, in May 1997, when the unemployment rate dipped below 5%.


Consider also the housing bubble from 2003 to 2007. In 2003, the Fed highlighted the risk of an "unwelcome substantial fall in inflation" as the justification for lowering the fed-funds rate to 1%. Then it kept monetary policy accommodative until the summer of 2006, when it finally reached a neutral stance. This was three years after the unemployment rate had started to decline to 4.6% from 6.3%.


In fairness, neither part of the Fed's "dual mandate" gave it any sense of great urgency. Inflation never got above 2.5% before the onset of the 2008 recession, and the unemployment rate didn't signal a need to tighten until the end of 2005, when it fell below 5%. Clearly the central bank was missing something during both episodes. It paid insufficient attention to balance-sheet measures like the rise in liabilities and asset prices, both of which clearly signaled that monetary policy was too loose.


Between 1995 and 2000, the ratio of household net worth to disposable income surged 33%. This measure is roughly akin to a price-earnings ratio for the entire country, and it had never experienced such a move. Money was clearly going into the stock market, even if not into the prices of goods and services that central banks typically focus on. The entire rise in wealth was undone during the subsequent stock-market crash. Then all of the gains to wealth were recreated between 2002 and 2006 as housing prices boomed.


Wealth-to-income ratios were not the only red alert being triggered. Over the period that encompassed both bubbles, the aggregate amount of credit in the economy rose steadily to more than 350% of GDP, from 225%. If the Fed had focused more on the growth of debt or asset prices instead of a narrow measure of inflation, it would have followed a tighter monetary policy.


Given recent history, surely the Fed needs to consider these measures, and perhaps to broaden its view of inflation to more actively include commodity prices, which have some track record of predicting inflation. Gold has served as an alternative currency for 2,000 years, and copper is a useful indicator of global production. Because these commodities are influenced by global economic forces, they cannot be the sole guide to U.S. monetary policy. But they should not be ignored either.


While some clarification of its price-stability mandate might help, the central bank is already required to keep credit growth in check. Its full legal mandate is as follows: "The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of monetary and credit aggregates commensurate with the economy's long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates."


Now consider current economic conditions. Housing prices have started to fall again and are dropping in 29 out of 30 leading cities. Aggregate credit is also dropping and will continue to contract as the nation finishes a long period of deleveraging. Within this lens, it easier to understand why Fed Chairman Ben Bernanke is still pursuing accommodative policy.


But if you wanted the Fed to stop, a single mandate for price stability is the wrong tool to use. Inflation by the Fed's preferred measure (the core PCE price index) is now below 1% and could be zero in a year's time—well below the global consensus among central bankers that inflation should be about 2%. A myopic price-stability mandate could actually lock the Federal Reserve into quantitative easing for years, given its inflation target. This would be an odd result for a movement that is hoping to persuade the Fed to do less, not more.


A better idea would be to broaden the Fed's mandate to fully examine the nation's balance sheet when making policy decisions. Skilled central bankers look for clues everywhere. Policies that limit their search make little sense in a complicated world.

Mr. Sumerlin is managing director of the Lindsey Group. He served as deputy director of the National Economic Council under President George W. Bush.


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