Congress sets the goals, the Fed sets the intermediate target
Over at TheMoneyIllusion I have a long post discussing Ben Bernanke’s recent comments on monetary reform. There is one issue that seems especially important, and I wanted to devote an entire post to the subject. Here’s Bernanke:
I want to raise a few practical concerns about the feasibility of changing the FOMC’s target, at least in the near term. First, whatever its strengths and weaknesses, the current policy framework, with its two explicit targets and balanced approach, has the advantage of being closely and transparently connected to the Fed’s mandate from Congress to promote price stability and maximum employment. It may be that having the Fed target other variables could lead to better results, but the linkages are complex and indirect, and there would be times when the pursuit of an alternative intermediate target might appear inconsistent with the mandate. For example, any of the leading alternative approaches could involve the Fed aiming for a relatively high inflation rate at times. Explaining the consistency of that with the statutory objective of price stability would be a communications challenge, and concerns about the public or congressional reaction would reduce the credibility of the FOMC’s commitment to the alternative target.
Second, proponents of alternative targets have to accept the fact that, for better or worse, we are not starting with a blank slate. For several decades now, the Fed and other central banks have worked to anchor inflation expectations in the vicinity of 2 percent and to explain the associated policy approach. A change in target would face the hurdles of re-anchoring expectations and re-establishing long-term credibility, even though the very fact that the target is being changed could sow some doubts. At a minimum, Congress would have to be consulted and broad buy-in would have to be achieved.
This is obviously a very difficult subject, and there is clearly no single right answer. And yet I sometimes feel that people confuse mandates and targets, so I’d like to offer a few perspectives that might be useful. Let’s start with the original intent:
1. The Fed’s mandate was enacted by Congress in 1977, and includes both “reasonable price stability” and maximum employment. I think it’s fair to say that 1977 was pretty close to the nadir of our understanding of monetary economics. I doubt one Congressman in 10 would have seriously thought the Fed could target inflation at say 2%. They would have been thrilled with 4% inflation. There is even a third mandate for low long-term interest rates, which is (rightfully) ignored.
2. On the other hand things change, and we now have a much better understanding of monetary economics. It’s probably reasonable to assume that the Congress of 2015, and the public as well, would prefer that we do not return to 4% inflation. Nonetheless, the 1977 law is pretty vague, and I’d argue that today a 4% NGDP target is just as compatible with “reasonable price stability” and “maximum employment” as a 2% inflation target.
Many of my friends criticize the dual mandate because the Fed can only target one variable at a time. I used to feel the same way, but now I’m slightly more forgiving of Congress. I think the dual mandate could be regarded as sort of aspirational—the Congress telling the Fed to do the best it can in producing a stable economy with something close to price stability and high employment. But again, given that the law was passed in 1977, it’s hard to believe that Congress envisioned they were instructing the Fed to hit any sort of single rigid inflation target, no one except a few monetarists would have even thought that possible in 1977.
Instead Congress was probably saying something like, “The Fed is one of many policymakers, we’d like them to do their part in contributing to good inflation and employment outcomes.” Or perhaps Congress was saying, “Here are our goals, you figure out the best way to achieve them.” If Fed officials think NGDP targeting is the most effective way to stabilize the economy, I think they already have all the authority they need under the very vague 1977 law. The only concession I’d make is that while I prefer a pure NGDP target which lets long term inflation fluctuate inversely to changes in long term RGDP growth, as a practical matter Congress does clearly care more about inflation than I do. Thus the actual target would probably be something like the Fed’s estimate of trend RGDP, plus 2%, where the trend gets re-estimated every 5 years. That allows some inflation variation, but not much.
Some readers of this post might feel I’m granting the Fed far too much discretion. If so, I’d encourage you to re-read my earlier post on Fed accountability. I think it’s reasonable for Congress to let the Fed determine how best to carry out the mandate, but then they should insist that the Fed clearly spells out its intermediate targets in such a way that monetary policy is clearly accountable, where we can say after the fact that the Fed did or did not hit its policy targets. In that respect, NGDP targeting is a vast improvement over the vague “2% inflation plus unemployment close to the natural rate” approach used in recent years. Under that approach it looks (to me) like monetary policy was clearly far too tight in 2008-13, and yet the Fed refuses to say that policy was much too tight, nor do they tell us why they don’t think it was too tight.
So by all means keep the dual mandate, but have the Fed move from two targets to one, so that the spotlight shines more clearly on their policy. Institutions that are highly accountable will do better, even if the managers are already very civic-minded. That’s because the accountability would make it easier for the Fed to take the tough decisions in periods like 2008-09 that it should have taken, but perhaps held back due to fears of provoking controversy. Under an ideal regime you want the Fed to be able to say, “Look, this is our mandate, we’ll do whatever it takes to hit the mandate.”
I’m not an expert on Congress, but I would think that the Fed would want explicit Congressional authorization for a major policy change such as raising the inflation target to 4%. That’s not price stability. But as for a NGDP intermediate target that was consistent with expected 2% inflation, Fed consultation with Congress should be sufficient.