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Contents Introduction Background on Monetary Policy The Relationship Between Inflation Targeting and the Mandate Has the Fed Already Adopted An Inflation Target? Evaluating the Rationales for a Single Mandate of Price Stability The Level and Stability of Price Inflation The Long-Run Neutrality of Money on Employment Stagflation: The Proper Response When Mandated Goals Diverge Transparency and Discretion Oversight and Accountability Credibility Recent Criticisms of the Fed's Performance: Would a Single Mandate Have Resulted in Better Outcomes? The Length and Depth of the Recession The Housing Bubble Quantitative Easing Failure to Respond to Rising Headline Inflation "Bailing Out" Too Big to Fail Firms Lax Supervision of the Financial System and Mortgage Markets Setting an Inflation Target: Implementation Issues Who Should Set the Inflation Target? What Level Should be Targeted? A Point Estimate or A Range? What Measure of Inflation Should be Targeted? Should There Be Penalties for Missing the Target?
March 13, 2012
The Federal Reserve's (Fed's) current statutory mandate calls for it to "promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." Some economists have argued that this mandate should be replaced with a single mandate of price stability. Often the proposal for a single mandate is paired with a more specific proposal that the Fed should adopt an inflation target. Under an inflation target, the goal of monetary policy would be to achieve an explicit, numerical target or range for some measure of price inflation. Inflation targets could be required by Congress or voluntarily adopted by the Fed as a way to pursue price stability, or a single mandate could be adopted without an inflation target. Alternatively, an inflation target could be adopted under the current mandate. In January 2012, the Fed voluntarily introduced a "longer-run goal for inflation" of 2%, which some might consider an inflation target.
In the 112th Congress, H.R. 4180 and H.R. 245 would strike the goal of maximum employment from the mandate, leaving a single goal of price stability. H.R. 4180 also requires the Fed to adopt an inflation target; H.R. 245 does not. Were a single mandate to be adopted in the United States, it would follow an international trend that has seen many foreign central banks adopt single mandates or inflation targets in recent decades.
Arguments made in favor of a price stability mandate are that it would better ensure that inflation was low and stable; increase predictability of monetary policy for financial markets; narrow the potential to pursue monetary policies with short-term political benefits but long-term costs; remove statutory goals that the Fed has no control over in the long run; limit policy discretion; and increase transparency, oversight, accountability, and credibility. Defenders of the current mandate argue that the Fed has already delivered low and stable inflation for the past two decades, unemployment is a valid statutory goal since it is influenced by monetary policy in the short run, and discretion is desirable to respond to unforeseen economic shocks. A case could also be made that changing the mandate alone would not significantly alter policymaking, because Fed discretion, transparency, oversight, and credibility are mostly influenced by other factors, such as the Fed's political independence.
Discontent with the Fed's performance in recent years has led to calls for legislative change. It is not clear that a single mandate would have altered its performance, however. Some of the criticisms, including lax regulation of banks and mortgages and "bailouts" of "too big to fail" firms, were authorized by statute unrelated to the Fed's monetary policy mandate. The criticism that the Fed was responsible for the depth and length of the recession arguably leads to the prescription that monetary policy should have been more stimulative; it does not follow that more stimulus would have been pursued under a single mandate. Whether or not the Fed allowed the housing bubble to inflate, it is not clear that a single mandate would have changed matters since the housing bubble did not result in indisputably higher inflation. Some economists believe that the Fed's recent policy of "quantitative easing" (large-scale asset purchases) will result in high inflation. Inflation has not increased to date, but even if these economists are correct, the Fed has discretion to pursue policies it believes are consistent with its mandate. It has argued that quantitative easing was necessary to maintain price stability by avoiding price deflation, and it could still make this argument under a single mandate.
This report discusses a number of implementation issues surrounding an inflation target. These include what rate of inflation to target, what inflation measure to use, whether to set a point target or range, and what penalties to impose if a target is missed.
The recent financial crisis and deep economic recession have led to criticisms of the Federal Reserve's (Fed's) handling of both. Critics have blamed the Fed for pursuing policies that allowed the housing bubble to inflate, for lax regulation of financial firms and mortgage markets that led to excessive speculation, for "bailing out" financial firms during the crisis, for failing to prevent the recession's unusual length and depth, and for engaging in "quantitative easing" that critics believe will result in high inflation. Although alternative explanations have also been offered for each of these criticisms, they have led some Members of Congress to question whether legislative remedies are needed to avoid similar problems in the future. In particular, some Members of Congress have argued that the Fed's statutory mandate should be modified.
The Fed's statutory mandate for monetary policy was set in the "Federal Reserve Reform Act of 1977." (1) It currently reads:
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. (2)
Although this mandate includes three goals, it is often referred to by economists as a "dual mandate" of maximum employment and stable prices. Some economists have argued that Congress should strike the goals of maximum employment and moderate long-term interest rates from the current mandate, leaving price stability as the only mandated goal. Often the proposal for a single mandate is paired with a more specific proposal that the Fed should adopt an inflation target. Under an inflation target, monetary policy would aim to achieve a predefined numerical target or range for some measure of inflation (the change in the general price level).
For at least the past two decades, bills have been introduced in Congress to switch the Federal Reserve to a single mandate of price stability. In the 112th Congress, Representative Mike Pence introduced H.R. 245 that would strike maximum employment from the mandate (it would preserve the mandates to maintain stable prices and moderate long-term interest rates); it does not include an inflation target. Also in the 112th Congress, Representative Kevin Brady introduced H.R. 4180, the "Sound Dollar Act of 2012." Title I of H.R. 4180 would strike the current mandate and replace it with a single mandate of long-term price stability. It would require the Fed to establish metrics (i.e., an inflation target) to evaluate whether the mandate was being achieved, and those metrics would have to take into account price indices of goods and services, asset prices, exchange rates, and the price of gold. The Fed would be required to publicly disclose the metrics and report to Congress when the metrics were altered. The bill would also replace current semi-annual "Humphrey-Hawkins" reporting requirements to Congress, which call for "a discussion of the conduct of monetary policy and economic developments and prospects for the future, taking into account past and prospective developments in employment, unemployment, production, investment, real income, productivity, exchange rates, international trade and payments, and prices," with reporting requirements on "whether the goal of long-term price stability is being met and, if such goal is not being met, an explanation of why the goal is not being met and the steps that the Board and the Federal Open Market Committee will take to ensure that the goal will be met in the future ," as well as a description of the instruments used and strategy employed to achieve price stability, and the effect of monetary policy on the exchange rate value of the dollar. The Sound Dollar Act also has other titles unrelated to the Fed's mandate.
Were a single mandate to be adopted in the United States, it would follow an international trend that has seen many foreign central banks, including those of New Zealand, Canada, Australia, and the United Kingdom, adopt price stability mandates, inflation targets, or both in recent decades. In January 2012, the Fed voluntarily announced a "longer-run goal for inflation" of 2%, as measured by the annual change in the price index for personal consumption expenditures. (3)
This report analyzes the economic arguments for and against shifting to a single mandate. It then analyzes possible effects of a mandate change on Fed policymaking in the context of recent criticisms related to the Fed's performance. It also discusses the advantages and disadvantages of different options for implementing an inflation target.
Background on Monetary Policy
Congress has delegated monetary policy responsibilities to the Fed, and requires the Fed to set monetary policy to achieve its mandated goals. In normal circumstances, the Fed implements monetary policy by setting a target for the federal funds rate, the overnight inter-bank lending rate. (During the recent financial crisis, the Fed has taken several unconventional steps to stimulate economic activity besides changes in the federal funds target. (4)) Generally, if the Fed wishes to moderate the growth in economic output and inflationary pressures, it "tightens" or "contracts" policy by raising the federal funds target. If it wishes to stimulate the growth in economic output and inflationary pressures, it "loosens" or "expands" policy by reducing the federal funds rate. (5)
Congress has given the Fed broad day-to-day discretion to choose the federal funds rate target that the Fed believes is compatible with its statutory goals. Congress retains oversight responsibilities, and those responsibilities are primarily exercised through Congressional hearings, including mandated semi-annual hearings in which the committees of jurisdiction receive a written report and testimony from the Chairman of the Fed. (6) If Congress finds the Fed's pursuit of its statutory goals to be lacking, however, it has limited "carrots" or "sticks" available to induce a change in behavior due to the independence Congress has granted the Fed. A fundamental problem with holding the Fed accountable for its performance is that it has a limited influence over economic outcomes. When the actual performance of the economy deviates from the mandated goals, the Fed can make the case, with some justification, that those deviations were caused by factors outside of its control.
Monetary policy is only one of the Fed's main responsibilities. Other responsibilities--including lender of last resort functions in a crisis and supervision of banks and the payment system--are laid out in other sections of the Federal Reserve Act and other parts of federal statute. Changing the Fed's monetary policy mandate alone would not alter the authorities governing the Fed's other responsibilities.
The Relationship Between Inflation Targeting and the Mandate
The statutory mandate sets the ultimate goals of monetary policy, and can be altered only through legislative action. The instruments, methods, and strategies that the Fed employs to reach those goals are not laid out in law. Inflation targeting can be thought of as a strategic approach--to focus policy on achieving a numerical target for inflation--to achieving mandated goals. Because it is a part of a strategy for achieving statutory goals, it could be codified through legislation or voluntarily adopted internally by the Fed.
Traditionally, proponents of a single mandate and inflation targeting have been one and the same. There is logic to the idea that if the Fed's sole focus of policy is going to be achieving price stability, then there should be a numerical target to help ensure that this goal is achieved …