Posts Tagged ‘IS-LM’

Fed’s dual mandate under assault

In International economics on November 23, 2010 at 3:14 pm

Bernanke tasked with achieving the dual mandate while there is no political will to assist

It seems that there’s more and more talk of the Fed’s dual mandate of price stability and full employment and whether it should exist. Critics say that most advanced economies’ central banks are charged only with the mandate of price stability, as they control the factors that contribute to inflation or deflation. Since the Fed’s inception, it has been charged with not only maintaining stable prices, but to keep growth high to maintain full employment. I thought that this would be a good discussion point for the US’ current plight: the Liquidity Trap.

IS-LM curve of an economy in a liquidity trap.

The problem with the dual mandate is that full employment is not solely controlled by the central bank. Especially in the current context where the United States is caught in a classic IS-LM liquidity trap, where monetary policy (LM) is unable to stimulate growth up against the zero-bound of interest rates. See the chart above for a representation of where the US currently is. Notice that a rightward shift in the LM curve (representing QE or other forms of expansionary monetary policy) would not produce sufficient expansion of output/employment, and only a demand-shock from the IS curve would lift the money market into normality and lift employment and output to sufficient levels. Simply put, fiscal stimulus is the only adequate solution to the US’ labor and money market woes. Federal funds will stay at the zero bound and unemployment flirting with double digits until the political will comes to boost growth and employment.

Back to the title of the post, why should the Fed be shackled with a dual mandate, when it is supposed to remain independent politically, but is faced with tasks that require political action? Stephen Roach, who I disagree with immensely on the topics of China’s currency manipulation and the economic policy issues surrounding trade with China and the mechanics with which they achieve the inflated exports to the US, actually has some wise points to make on this issue. In an Op-Ed piece in the Financial Timesthe half-professor, half-puppet of Chinese economic policy shares his personal view of the dual mandate outlined in the Federal Reserve Act and subsequent acts:

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.

Despite how I feel about Roach’s views on Chinese/US trade, he seems to have a point here. If the Fed is supposed to maintain credibility as an independent organization that is uninfluenced by political noise, then how can it be tasked with achieving goals that require political mobilization? I wouldn’t go as far as Roach and add a third mandate of financial stability to the Fed, instead I think the Fed should undergo an immediate two-fold reform:

  1. End the full-employment mandate. The Fed is only one part of a multi-faceted function that determines employment in the economy. They should instead just be charged with facilitating robust credit markets in conjunction with price stability. This will maintain their independence and narrow their focus, and leave the other “IS” issues to the elected bodies who truly have control over them.
  2. Set an outright numerical inflation target zone. Many from the BIS and IMF have recently stated that higher inflation targets that are explicitly stated as the goal for central banks are the most effective tools for managing price stability. If the Fed targeted the 2.5-4% range, it would achieve moderate inflation that is most conducive to continued economic growth and healthy financial markets. This would give them a large window to adjust rates from “normal” levels, and combat deflation and sluggish output.

It’s doubtful that either Roach or my suggestions will be implemented, but hey, we can always dream right?