The WSJ blog has a note on a speech by Fed Vice Chairman Donald Kohn earlier today. He argues (along with a survey paper he discusses by David Laidler, which I would love to read if I found it) that the monetary policy has two unanswered questions: What's the best way to support the goal of price stability? And how do asset prices help you steer monetary policy?

That answer, he points out, is fundamentally different in the U.S. and Europe, and makes a very political argument for this:

A formal inflation target represents a national embrace of a goal, in which elected authorities recognize the primacy of price stability and publicly support--indeed, even require--the central bank's pursuit of that goal. To the extent that elected authorities channel the desires of the electorate, a central bank directed to adopt an inflation target is being given a strong signal as to the goal's importance to the public at large. This affirmation has often been reinforced by the granting of operational independence to the central bank to achieve that goal most effectively. An important effect of such public acceptance of price stability is that it erodes the standing of those who would direct central bank action toward other ends. In such an environment, workers, businesspeople, and investors can make plans with the expectation that nominal magnitudes will be predictable and so devote their attention to more productive matters.

For the European Central Bank, this framework was established by treaty. In most other instances, the adoption of an inflation target involved laws and mutual understandings, not constitutional changes. The early adopters of inflation targets were parliamentary democracies, which is not too surprising given that in such a system a single branch of government can enact laws and put them into effect. With regard to an inflation goal, the parliament can erect the formal apparatus and the finance minister can serve as the government's point of contact with the central bank.

The system in the United States is different in that two independent branches of government are responsible for economic policy making, making agreement on a single goal problematic. Moreover, those two branches have already spoken as to the appropriate aim of the nation's central bank: The Congress, in a law the President signed, has given the Federal Reserve a dual mandate that directs us to foster maximum employment and stable prices over time. This instruction is not an accident of history, in that, in the past, the Congress has shown no appetite to amend its legislation.

I am amused by that last line, as it sounds a good bit like the argument for the antitrust exemption in baseball. The problem with it is that the Fed's independence is quasi-constitutional, in that it likely could not be done without a long public debate and would require broad acceptance of the changes proposed. So arguing that everyone likes the dual mandate -- adopted in 1913 -- because Congress hasn't changed it suggests we have the same understanding of inflation now as then. We don't. But the line does require people to say things like Governor Warsh did this afternoon, that their mission is to watch the real economy. That's not what we teach in intermediate macro.

Not even Kohn, as he then argues that our there's no inherent difference in the dual versus single mandate:

Nor is this instruction unreasonable, in that the dual mandate has come to be interpreted as assigning us the responsibility for attaining price stability in the long run, which will bring with it maximum employment, and of being mindful of resource utilization in the succession of short runs that make up the long run. The dual mandate seems proper and fitting, given that economic costs are incurred both by having inflation stray from its long-run goal and by having output deviate from the economy's potential to produce; and it seems to produce results not too different in practice from those associated with central banks that are flexible inflation targeters.

You could not have made that argument even 25 years ago, yet it seems so facile now.

Sure, you can argue that in the long run price stability maximizes output, but at what point is your performance evaluated? And when you have the goals the Fed does, you are subject to complaints like knzn's,

We want a stable financial system (even though the system is constantly evolving); we want stable prices; we want stable interest rates; we want stable employment; we want this; we want that; � The macroeconomy is like a spoiled child demanding all sorts of subtle and incompatible things. Rather than trying to make the child (who, by the way, isn�t very good at making decisions, since he has to use the democratic process to do it) specify �I�m willing to accept X amount of interest rate variance in exchange for Y amount of inflation variance� and so on, isn�t it better just to appoint a wise and respected nanny to make the necessary compromises?

...to which the lack of a single goal makes life difficult for the Fed. And yet you when you have people who argue for price stability uber alles, you have no leg to stand on either.

When people asked me why the Fed went to 50 bp on Tuesday night, I said the Fed knows something we don't. As I said a while back, they had to have seen the CPI report that wasn't public until Wednesday morning. I don't think the Fed necessarily believes the economy is headed for a recession, given some of the data that's out there, but the good price report gave them reassurance that they would have some room to deal with the growth side of the mandate. William Polley says pretty much the same thing in the second point here. He also talks of what happened to the long bond as the announcement occurred (he was with students on a field trip to the Chicago Board of Trade at the time of the announcement):

From the gallery in the CBOT, we watched it happen as the 10 year numbers went red and you just wanted to have a moment of silence for the passing of low inflation expectations. You teach this stuff for years, saying "this is what can happen..." and then it does.

I have to admit that the market reaction troubled me a bit. They didn't get the message. Or they got the wrong message. Or worse...they got it just right.

I think that's the problem with the dual mandate; you are not sure if the weight the Fed places on inflation changed, or if their forecast is for core inflation to subside, or ... whether they got that right. I do not think it matters even if you were to have the Fed adopt inflation targeting, though it would help. As much of the world has moved to a sole price stability mandate as has moved to inflation targeting (Fed Governor Mishkin makes that point here), but that requires an act of Congress, one that may come before or after they get around to removing baseball's antitrust exemption.

Labels: economics