The Fed’s Sole Mandate — Lev Menand

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Mike Norman
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 This is an important post by a law professor. Hat tip to Adam Tooze for pointing me toward it. Here is a key excerpt. According to Professor Menand, the Fed's sole mandate is promoting full capacity utilization and not chiefly managing inflation or running a command economy based on monetary policy decisions. The Fed has only a contributory role. Presently, it is widely assumed that the Fed has a mandate to manage the economy using monetary policy either as a replacement to fiscal policy or as a counter to it using the central bank "reaction function."

Here is a key excerpt:

In 1977, Congress added Section 2A to the Federal Reserve Act, charging the Fed with “maintain[ing the] 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.” Note that, in this instruction, maximum employment and stable prices—the two functions that commentators tend to highlight today—are included as among the macroeconomic consequences of full capacity utilization, rather than as competing desiderata that the Fed is supposed to trade off. The animating idea is that when the economy is growing at its fullest potential, everyone who is able to produce goods and services will have a job, prices will be stable, and the cost of borrowing money for further investment will be moderate. Bringing about these macroeconomic conditions is not a direct goal for the Fed; rather, the Fed’s mission is to administer the banking system in a way that grows the money supply at a rate that is consistent with achieving them over the long term.

The legislators and Fed officials at the time understood Section 2A to be merely reiterating the Employment Act and incorporating it expressly into the Fed’s own organic statute. As the Fed’s Chairman, Arthur Burns, put it, the text, initially included in a 1975 resolution, “adds nothing new to the objectives of Federal Reserve policy as already defined by statute [in the Employment Act]”). The Fed’s job, as policymakers then recognized, was not to combat inflation—it was to ensure that banks create enough money and credit to keep the nation’s productive resources fully utilized, which meant pursuing maximum employment. Congress, in other words, designed the Fed to keep the economy growing, not slow it down for the sake of stable prices in the short-to-medium term.

This distinction is important because there are many reasons that, in the short-to-medium term, the economy might not achieve full potential—as manifested by maximum employment, price stability, and moderate long-term interest rates. And often these reasons have nothing to do with monetary expansion, the only variable Congress expected the Fed to control. For example, supply shortages of key goods and services can cause prices to rise for months or even years while producers adapt to satisfy changing market demand. The Fed’s job is not to stop these price rises—even if policymakers might think stopping them is desirable—just as the Fed’s job is not to engineer long-term interest rates so that they are “moderate” or to lend lots of money to companies so that they can hire more workers. The Fed’s job is to ensure that a lack of money and credit created by the banking system—an inelastic money supply—does not prevent the economy from achieving these goals. That is its sole mandate.

Professor Menand is not saying that this is a desirable way to proceed, or simply advise. He is claiming it is integral the the institutional arrangements by which the legislature has delegated certain powers and responsibilities to the Fed regarding monetary policy and US central bank operations.

Where did things go wrong? In the adoption of Milton Friedman's monetarism along with subsequent iterations, from which the Fed and a large swath of the intelligentsia have so far not recovered.

But what about increasing interest rates adding to fiscal flows, hence, acting as a stimulus, which this policy does. Professor Menard points out that the purpose of increasing interest rates is to cool the economy by making the cost of borrowing more expensive, hence reducing investment by lowering profitability. While increasing rate does increase Fed interest payments on reserves does act as a stimulus as a fiscal add, this increase in the interest rate is also a price rise and adds to inflation, the opposite of what the Fed intends. Simultaneously, it also reduces investment by adversely affecting profitability, which eventually reduces supply and increases prices even more, while lowering output and increasing unemployment.

Why would the Fed do this? The reasoning is simple. It is assumed that inflation is due to wage pressure, hence increasing interest rates will lower profitability leading to reduced employment which increases competition for existing jobs, lowering wage pressure.

This is a two-variable approach (Philips curve) to a more complicated issue in that there may be more variables involved, and, in fact, the problem may not be related to wage pressure, as is assumed, but rather, be based on supply contraction.

Professor Menand doesn't go deeply into these economic issues and the relationship of economics and finance, but only points to them. MMT economists do examine them in detail.

The importance of this article lies in showing how the MMT position on institutional arrangements is correct from a legal and regulatory perspective.

I should also mention in this regard that law professor Rohan Grey has also been ably presenting the MMT case from the legal perspective.