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Time to Change the “Dual Mandate”
By Mel Miller

The Federal Reserve is coming under growing criticism for actions taken during and since the Great Recession. In light of the political acrimony which currently permeates Washington, DC, I am concerned that any decisions that will change the workings of the Federal Reserve could merely be politically motivated and not in the best interests of the public. That being said, I do favor a change in how the Fed operates which I feel is in the best interests of the public and is not politically motivated.

Before I share my ideas, a brief review of the history of the Fed (Federal Reserve Bank) is in order.

The National Banking Act of 1863 provided for national chartered banks whose currency was backed by U.S. government securities. An amendment to the Act created a tax on state bank notes, but not national bank notes, resulting in the creation of a national currency. The nation was plagued from 1873-1907 with numerous bank runs and financial panics. It became obvious that the banking system in the U.S. needed reform.

In 1907, the nation endured a serious Wall Street collapse and a banking panic. The Aldrich-Vreeland Act of 1908 was enacted into law allowing for emergency currency issuance during a crisis. It also set off a debate as to whether the central bank should be controlled by the banks or the public.

Based on recommendations from Virginia Representative, Carter Glass, and financial expert, H. Parker Willis, the Federal Reserve Act was created. The Federal Reserve Act was signed by President Woodrow Wilson on December 23, 1913 creating a decentralized central bank with many Congressional checks and balances. Congress has oversight for the entire Federal Reserve System, and gave the Fed autonomy to carry out its duties without political pressure.

What are the goals of the Fed? In 1977, Congress amended the Federal Reserve Act to clarify the goals of monetary policy. The Fed currently operates under the following provision of the amended Federal Reserve Act:

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall 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.

The governing principles are also known as the “dual mandate”—full employment and stable prices.

I am troubled by the dual mandate. Attempting to meet the goals of the dual mandate often creates cognitive dissonance inside the Fed—debate about which of the two mandates has priority.

As an example, during the 1970’s, inflation exploded reaching an annual rate of just under 14% in 1979. The newly elected Chair of the Fed, Paul Volcker, implemented a high interest rate policy designed to slow the economy and reduce inflation to an acceptable level. As inflation was slowing, unemployment was soaring, reaching a high of approximately 11% by the end of 1982. The Fed, under Volcker’s leadership, realized that only one component of the dual mandate was achievable at the expense of high unemployment.

I did not view this as a success for the Fed. Millions were unemployed even as inflation declined. It is obvious to me that the Fed often must choose between the lesser of two evils—high inflation or high unemployment. This decision leaves the markets in a quandary as to the direction of short-term interest rates.

The markets (also the average consumer) want transparency. Because of the conflict brought about by the “dual mandate,” the Fed often tries to disguise the future direction of interest rates.

I think it is time to reform the dual mandate rule to provide clarity and to recognize that monetary policy alone cannot meet both elements of the dual mandate. In my “perfect world,” the Fed’s only mandate would be to control inflation; no more second guessing as to which element of the dual mandate is the current focus of policy.

Currently the Fed has a stated 2% inflation policy (this happens to be the current inflation rate for the past twelve months). Does the Fed need to raise rates if the inflation rate moves higher even as the economy operates below full employment?

I argue that fiscal policy should be responsible for maintaining full employment. Why not recognize the short comings of the free market system? When the private sector falls short of creating sufficient jobs, the public sector should become the employer. I like certainty—the inflation limit of 2% and the unemployment limit of 6%.

The Fed, under my model, would be responsible for inflation and Congress would be responsible for employment. A very transparent and totally unachievable model!

My plan has elements abhorrent to each side of the Congressional aisle, so I know it would never pass. However, I predict that Fed reform will become a major political issue following the mid-term elections this fall. The major risk is that Congress will want added control over the Fed without accepting the full employment mandate. It is an important topic and bears watching.

 

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Posted: September 17, 2014