Mission creep? The U.S. Federal Reserve is widely said to have two mandates: maintaining maximum employment and stable prices. Congress actually gave it three: maintaining maximum employment, stable prices and long-term interest rates. But the Fed may now have given itself a third mandate of its own: maintaining financial stability.
At the Oct. 9 announcement of her nomination to be the next Fed chair, Janet Yellen, currently vice-chair, said that strengthening the economic recovery and boosting employment would be her priorities if confirmed. “The mandate of the Federal Reserve is to serve all the American people, and too many Americans still can’t find a job and worry how they’ll pay their bills and provide for their families,” she said in a widely played made-for-TV soundbite.
But the key passage of her remarks was this:
If confirmed by the Senate, I pledge to do my utmost to keep that trust and meet the great responsibilities that Congress has entrusted to the Federal Reserve — to promote maximum employment, stable prices, and a strong and stable financial system.
It is the final six words of that sentence that redefine the triple mandate. This is more than a semantic change. Managing the trade-off between joblessness and inflation over the course of a business cycle is one thing; managing a three-way trade-off involving financial-sector risk is an altogether more complicated matter. The Fed has been struggling with this ever since the 2008 financial crisis without explicitly saying so — a fact that goes some way toward explaining the difficulty the central bank has had in communicating its intentions over monetary policy, and in particular the timing of the winding down of its massive asset-buying program.
This particular generation of top Fed officials have had their policymaking tools forged in a singular environment. The accommodative monetary policy adopted in the wake of the dotcom bubble bursting in the early 2000s was the textbook two-mandate response to the job losses of a recession. However, the soaring indebtedness it engendered led eventually to a mortgage meltdown that turned into a spectacular implosion of the financial sector.
Yet, despite this searing experience — or perhaps because it is still too recent for its policymaking ramifications to be fully understood — Fed officials have continued to talk publicly and in their post-Federal Open Market Committee meeting statements about monetary policy objectives in terms of just unemployment and inflation.
In a politically less dysfunctional economy, monetary policy could focus on jobs and price stability, and leave financial stability to macroprudential regulation. But at a time of extraordinary acts of central banking, the Fed has felt it necessary to press its monetary-policy tools into action in the cause of financial stability.
It is a possibility one Fed governor, Jeremy Stein, alluded to as long ago as last February, and another, the New York Fed’s William Dudley, spoke of in June. Dudley titled a speech given at Bank of International Settlements “Why Financial Stability is a Necessary Prerequisite for an Effective Monetary Policy.” Though he didn’t express it this way, he suggested central banks need to get their retaliation in first: a “central bank has a major role to play in ensuring financial stability,” he said. One reason for that is the financial-markets seine that monetary policy passes through from central bank to real economy has changed out of all recognition in the past three decades of financial liberalization and globalization.
The Fed’s unexpected decision after its September meeting not to taper its stimulus in the face of the increasing fiscal folly being exhibited in political Washington may in retrospect indicate that financial instability is being weighed in the balance of the Fed’s monetary-policy decisions far more extensively than had been realized from the outside. To be sure, there is a difference between financial-market volatility and financial-market stability. But if the Fed has assumed a new triple mandate, it would be well served to make that clear. Yellen may have taken first steps in that direction even before she starts the job.