Mandate drift at the Fed is normal

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The Federal Reserve has gone astray. It is under pressure from political forces that want it to try anything but ordinary central banking. Monetary policy makers seem more interested in talking about climate change and race relations than talking about inflation. The Fed’s modest tightening reflects an overly optimistic attitude towards economy-wide price pressures.

Politicians are as much to blame as technocrats. As a creature of Congress, it’s up to Congress to set the Fed’s course. The longer the Fed wanders aimlessly, the worse off we will all be.

Mission drift and mandate drift are the rule, not the exception, at the Fed. It’s time to get the world’s most important central bank back on track. Let’s start with the basics. What is the Fed for?

Most people know that the Fed has a dual mandate: maximum employment and stable prices. But few know that there is in fact a third element: moderate long-term interest rates. Policymakers, academics, and legislators have tacitly agreed to downplay the last part, and for good reason. Interest rates are determined by supply and demand in global financial markets. Even the Fed, with all its power, has little control over these fundamental economic forces. Yet the gentlemen’s agreement to reduce triple tenure to dual tenure reflects a worrying trend — the Fed is happy to go its own way, and its nominal overseers are happy to let it.

Here’s another thing: the Fed was never intended by its creators to be a central bank. During debates about the creation of the Federal Reserve System more than 100 years ago, its proponents assured the public that the Fed would operate as an augmented clearinghouse, facilitating rapid transfers of liquidity to avert incipient bank runs.

Americans were familiar with European central banks. They didn’t like what they saw. Central banks were oligarchic, quasi-aristocratic institutions that did not fit well with the American spirit of republican democracy. We had the Fed largely because its boosters promised it would not become what it is today. The Fed has been a chameleon since day one.

Currently, the battle for the future of the Fed hinges on the appointments to the Board of Governors. President BidenJoe BidenBelarusian President says Putin ‘completely sane’ and ‘in better shape than ever’ Arizona Democrat tests positive for COVID-19 drew heavy criticism for its choice of candidates. He deserves it. Although Sarah Bloom Raskin has withdrawn, the fact that she was nominated first is alarming. As for Lisa Cook, her respectable academic credentials and expertise on racial inequality have nothing to do with monetary or financial policy. But give the president and his advisers credit for knowing the lay of the land. Given the partisan gridlock in Congress, the best chance of leading the Fed is to support, rather than curb, mission creep.

Still, there is hope for a bipartisan consensus on a refocused Fed. The power to create liquidity, allocate credit and regulate banks for ideological reasons is too tempting to ignore. As long as backhanded control over the mighty heights of finance is on the table, proponents have a very strong incentive to step up their efforts to capture the Fed. Everyone would be better off if we could escape this arms race. The best way to lower the stakes is to refine the Fed’s mandate and keep it within explicit and well-defined limits.

When it comes to monetary policy, Congress should force the Fed to focus on a single dollar-denominated variable. Inflation is the most popular option. While not the best conceivable rule, it is probably the best achievable rule. But while the Fed has chosen an inflation target for itself, it refuses to specify a concrete trajectory for the purchasing power of the dollar. This means we have no benchmark to judge the Fed’s performance. Congress should correct this error. At the same time, it should remove the superfluous employment and interest rate component from the mandate. If the Fed does its job of keeping inflation low and predictable, the other factors will take care of themselves.

When it comes to regulatory policy, Congress needs to make clear that the Fed’s commitment to financial stability does not allow it to tinker with anything that might affect banks’ balance sheets. If the current statutes truly allow the Fed to tinker with environmental and social policy, there are no principled limits to its power. This is obviously false. The best thing Congress can do for financial stability is to force the Fed to focus on capital adequacy. Banks should maintain a buffer to absorb short-term financial shocks, and the Fed is an appropriate agency to control this. But anything more expansive, like directing credit to favorite organizations and causes, is unacceptable.

The American public has never consented to the Federal Reserve as it exists. Correcting this oversight is crucial. We have to decide, as long as we have a central bank, what we want it to do. The best feasible reforms tighten the Fed’s leash. A constrained Fed is a competent Fed. A runaway Fed is a danger to the public.

Alexander William Salter is a Senior Fellow at the American Institute for Economic Research and Associate Professor of Economics at Texas Tech University’s Rawls College of Business, Fellow at TTU’s Free Market Institute.

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