November 18, 2010 / 10:43 PM / 9 years ago

FED FOCUS-Dual mandate or single, Fed still would ease

CHICAGO, Nov 18 (Reuters) - The U.S. Federal Reserve would likely be easing policy aggressively even if its sole mandate were to pursue price stability, a change that some Republicans in the U.S. Congress are pressing for.

A call by two influential lawmakers this week to strip the goal of full employment from the Fed’s mandate tapped into a slew of criticism against the central bank’s new $600 billion bond-buying program. [ID:nN16134115] The purchases are designed to boost the economy, but detractors say the policy is driving the dollar down and sowing seeds for inflation.

The central bank’s two-sided mandate puts the Fed in an awkward position at times. Actions to lower unemployment could risk lifting inflation, as critics now contend.

Similarly, the very tools the Fed uses to fight inflation — raising interest rates — can in the short-term hurt employment.

That was the case in the early 1980s, when then-Fed Chairman Paul Volcker jacked up rates to tame fast-rising prices, incurring the anger of the homebuilding industry, which blamed him for destroying jobs.

But with the unemployment rate nearly double what Fed officials think could be sustained without generating price pressures, and inflation well below the 2 percent level officials associate with price stability, it is hard to argue the mandate is producing mixed signals now.

“There are plenty of times when the signals point in different directions — why on earth would it be confusing to announce a change in policy at a time when the signals point in the same direction?” said Harvard economist Jeffrey Frankel, who served as an economic adviser to President Bill Clinton.

Indeed, the U.S. central bank already emphasizes the inflation-fighting side of mandate. Fed officials have long argued that low, stable inflation is a necessary ingredient for achieving the highest level of sustainable employment.

“Both goals are equal, but some are more equal than others, and if you had to pick one, it’s the inflation goal that’s more equal,” said Paul Ashworth, a senior U.S. economist at Capital Economics in Toronto. “I don’t think (the Fed) is putting undue weight on the unemployment rate.”

Core consumer prices posted their smallest year-on-year rise in the period through October, edging closer to growth-sapping deflation.

“I don’t see particular need to change (the dual mandate) at this time,” said former Fed Governor Randall Kroszner, a professor at the University of Chicago who was appointed to the Fed by Republican President George W. Bush.

LESSONS FROM JAPAN

Kroszner said the Fed is already acting aggressively on its price-stability mandate by moving to head off deflation.

“The situation we have here is exactly the situation Japan had when inflation kept moving lower and lower,” he said.

Fed officials say Japan has been dogged by deflation for 15 years precisely because the Bank of Japan waited too long to act.

Fed Vice Chairwoman Janet Yellen highlighted deflation risks as she defended the central bank’s bond-buying program.

“Even if we do not experience deflation, continued disinflation could weaken the recovery further,” she told the Wall Street Journal.

Marvin Goodfriend, an economics professor at Carnegie Mellon’s Tepper School of Business who served as a top adviser at the Richmond Federal Reserve Bank, said he supports the idea of placing explicit priority on the inflation-fighting side of the Fed’s mandate.

“It appears to me that the Fed may be putting an undue emphasis on reacting to employment at the risk of higher inflation,” he said.

That in turn could encourage markets to doubt the Fed’s commitment to keep inflation under control, which could cause the bond-buying program to backfire by pushing up yields on long-term government debt, he said.

TIED HANDS

But some argue narrowly focused mandates carry their own risks.

At the Bank of England, which is bound by an inflation target, Monetary Policy Committee member Adam Posen has advocated for further quantitative easing to boost slow growth and cushion the economy from looming government budget cuts.

However, with inflation running slightly above the bank’s 2 percent target, his arguments have made little headway.

Closer to home, some worry that a narrower Fed mandate could compound policy mistakes.

The Fed has been criticized for keeping monetary policy too loose during the 2003 to 2005 period, feeding the housing bubble that ultimately burst with disastrous consequences for the economy.

But that policy was driven by fears of deflation, and the Fed might have pursued it for even longer if price stability were its only mandate, Harvard’s Frankel said.

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