I've changed my mind on the Fed's mandate
By Scott Sumner
I’ve been obsessed with monetary policy for most of my life and at age 64 I rarely change my mind on this issue. But today I’ve changed my mind on the Fed’s so-called dual mandate, which is actually a triple mandate:
In 1977, Congress amended the Federal Reserve Act, directing the Board of Governors of the Federal Reserve System and the Federal Open Market Committee to “maintain long run growth of the 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.”
Economists have tended to ignore the “moderate long-term interest rates” part of the mandate, for two reasons. First, it’s widely believed that the Fed does not have much impact on long-term interest rates, except by controlling the trend rate of inflation. Second, the Fed’s 2% inflation target already insures relatively moderate long-term interest rates, which suggests that the third mandate is redundant. Recall that the high interest rates of the late 1970s reflected high inflation expectations.
I used to buy into this view, but now I believe we should take the third mandate seriously. But what does “moderate” interest rates actually mean? And what do we mean by “mean”. As an analogy, did the legislators who banned discrimination based on gender back in the 1960s intend that this law would also apply to discrimination based on sexual orientation? And is that what matters, or should we think in terms of how they would view their intentions from the perspective of 2020—if they could be transported here in a time machine? The Supreme Court recently struggled with that issue.
I suspect that in 1977, legislators meant by “moderate” something like “not too high”. But the actual term “moderate” does not literally mean “not too high”, it means not at either extreme. We also know that once long-term interest rates hit unimaginably low levels of zero of even negative in places like Germany and Japan, many public officials became concerned that low rates were hurting savers. Thus it is not unreasonable to assume that “moderate” means avoiding both really low interest rates that would hurt savers and really high rates that would hurt borrowers. This interpretation meets the letter of the law as well as the likely intent of legislators once they understand that zero or negative rates on long-term bonds are possible, something they may not have even imagined in 1977.
In the recent case where the Supreme Court applied the 1964 Civil Rights Act to discrimination based on sexual orientation, I believe they were at least partly motivated by the fact that society increasingly opposes this sort of discrimination. That may not be legally sound reasoning, but I especially doubt whether the four “liberal” justices would have used this sort of creative interpretation if it had led to what they saw as a highly objectionable public policy outcome. Thus liberal justices use the vague “right to privacy” concept in abortion cases but not heroin possession cases.
If we return to monetary policy, then there are two very pragmatic reasons why we might choose to take the third mandate seriously. If one interprets “moderate long-term interest rates” as long-term T-bond yields in the historically normal range of 3% to 6%, then it can be seen as requiring that the Fed insure a NGDP growth rate that it high enough to keep long-term rates in that normal range, at least most of the time. And I don’t believe the Fed is currently doing that. Ten-year T-bonds yield barely 1/2%.
I see two advantages to maintaining a trend rate of NGDP growth that is fast enough to keep long-term rates moderate:
1. Less of a zero lower bound problem for monetary policy. While it is possible to do effective monetary stimulus at the zero lower bound, in practice monetary policy usually becomes too contractionary at the zero bound.
2. A smaller Fed balance sheet. At the zero bound the demand for base money rises rapidly. This leads to the Fed buying lots of assets to meet this demand, and this might have a distortionary effect on the economy. This is especially true if they continue their recent policy of going beyond the Treasury market in their asset purchases.
Thus in order to keep away from the zero lower bound and to maintain a small Fed balance sheet, it makes sense to take the third mandate seriously.
You might think that “low interest rate guys” like President Trump would oppose this policy change. But that’s reasoning from a price change. In this case, the higher nominal interest rates would be achieved through an expansionary monetary policy (a NeoFisherian approach) and hence would have more support from politicians than you might normally assume from the phrase “higher interest rate policy”. My proposal would not raise real long-term interest rates and would boost growth in the short run.