Thursday, November 15, 2007

Does the Fed's dual mandate spell doom for the dollar?

The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain 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.

[12 USC 225a. As added by act of November 16, 1977 (91 Stat. 1387) and amended by acts of October 27, 1978 (92 Stat. 1897); Aug. 23, 1988 (102 Stat. 1375); and Dec. 27, 2000 (114 Stat. 3028).]


In the wake of the Fed's 0.75% easing over the past couple of months and the subsequent collapse of the US dollar, Macro Man has been giving thought to the notion that the fundamental construct of US monetary policy is inherently disadvantageous to foreign holders of dollar-denominated assets, and that the apotheosis of this long-term trend may be upon us. He briefly sketches out these thoughts below, and welcomes reader comments.

The Federal Reserve Acts of 1913 and 1977 laid out the policy objectives of the Federal Reserve System. The text of the latter Act, quoted above, spelled out in specific terms what has become known as the Fed's "dual mandate": namely, to promote maximum employment and low inflation. Of course, taken literally, one could argue that there is in fact a triple mandate, with asset-price targeting in the bond market as the third leg of the policy tripod.

Now, whether one assumes a dual or a triple mandate, it is clear that the Fed's policy objectives differ from those of most other major central banks. The Bank of England, for example, has a specific CPI target of 2% over a two year horizon. The ECB has a "primary objective of price stability", which the ECB has chosen to define in its own fashion. There is a secondary objective of supporting the economic goals of the EU (maximum employment and stable non-inflationary growth), but price stability takes primacy. The RBNZ has an explicit policy target of keeping future CPI inflation between 1% and 3%.

The difference here should be clear. Banks like the ECB, BOE, RBNZ, and others have an explicit primary policy target of price stability. That comes first and foremost. The Fed, on the other hand, must balance its focus on price stability, which it shares with other CBs, with an explicit focus on supporting economic activity so as to reach its equally important goal of maximizing employment.

Now many commentators, including Macro Man, have given Alan Greenspan and Ben Bernanke a lot of stick for being serial bubble blowers. But perhaps some of that criticism is misplaced. Perhaps where we should really direct our ire is the Federal Reserve Act itself, which essentially directs the Fed to ignore the inflationary consequences of its actions if it judges those consequences to be less severe in relation to its policy goals than a potential loss of employment. What Macro Man is saying here is that there is no such thing as a "Greenspan put" or a "Bernanke put"; what it is is a "Federal Reserve Act put."

When you think about it, the practical implications of this policy structure are quite significant. The Fed's dual mandate essentially carries with it an implicit promise that Fed policy will be more "dilutive" (to borrow a term from occasional poster Mencius Moldbug) than policy in most other developed economies. While this is not necessarily a bad thing for US residents, for whom maximum employment, broadly stable prices, and moderate long-term interest rates are surely worthy goals, it is a decidedly unpleasant outcome for non-resident holders of US dollar assets.

Simply put, the Federal Reserve, as a matter of policy, is less interested in protecting the international purchasing power of its currency than other central banks are. Such a policy focus is really quite remarkable for the central bank of THE hegemonic reserve currency, and no doubt explains why the FX reserve managers are, broadly speaking, trying to reduce (or at the very least not increase) their dollar holdings as a percentage of their reserve baskets.

It is also a damned good reason why the dollar pegs of current account surplus countries, particularly those with high inflation, are wildly inappropriate. The Fed's implicit promise to sacrifice the international purchasing power of the dollar (and by extension under current policies, the renminbi, riyal, dirham, etc.) to support domestic employment as a matter of course is wrong, wrong, wrong for China, Saudi Arabia, the UAE, etc.

Policymakers in these countries are finally becoming aware of this, with the UAE the latest country to suggest a change to its dollar peg- and not before time. Private investors evidently knew the score a year or two ago, which has resulted in a buyer's strike of US dollar-denominated financial assets, leaving the mercantilists and the oil producers holding the bag.

So where to go from here? Unless something changes, it is very difficult indeed to see private sector investors step in to buy dollar assets unless they are allowed to get cheaper (either in dollar terms or via a much lower dollar.) That having been said, a couple of caveats.

The Fed took a small step, in Macro Man's opinion, towards recovering an element of credibility by suggesting yesterday that their medium-term price target is headline, rather than core, inflation. By starting to forecast headline inflation (which necessitates that they pay attention to it), investors can derive at least a modicum of satisfaction that they may not be completely sacrificed at the altar of ex-food and energy.

Moreover, the currencies that have heretofore carried the load in strengthening against the dollar are starting to develop some serious warts. Yesterday's UK inflation report hinted at a significant downturn in growth even if the BOE cuts rates. Unusually, Mervyn King noted that currency tensions will be discussed at this weekend's G20 meeting in Cape Town. EMU monetary conditions are the tightest in 15 years, and surveys are suggesting an imminent downturn. Canada's leading indicator posted its lowest reading in several years yesterday, and BOC deputy governor Jenkins has complained about the strength of the loony recently.

What it all means is that we may be rapidly approaching that Minsky moment when dollar-peggers have to change policy. At that point, we could actually see currencies like the euro and sterling decline against the buck, with dollar weakness manifesting itself most against erstwhile peggers. For the time being, reserve diversification flows should keep the euro broadly supported for the next month and a half, but Macro Man is now entering profit-taking mode on his euro long.

Ultimately, what we are witnessing is a second Nixon shock played out in slow motion. And the Fed's dual mandate ensures that John Connally's remark from 1971 holds true today: "the dollar is our currency, but your problem."

17 comments:

Anonymous said...

Regarding the inclusion of headline inflation in their forecast,I thought the same thing as you did MM, but then I read the passage in the speech pertaining to the "most appropriate pace of disinflation" which is essentially Ben saying "inflation may be high, but trust us, whithin 3 years we'll bring it back down".
If he wants us to believe him, he has to earn his spurs first, which is going to entail sacrificing a bit, not all, of the empolyment side of the mandate. For we have been told repeatedly that sustainded low inflation is the best way to ensure long run low employment. And I think thats right.
Great post MM.
RJ

Bureaucrat said...

MM,
whether de facto the FED is paying less attention to inflation than other CBs is ultimately an empirical question that one could e.g. approach through looking at whether the US has lower coefficients on inflation gaps in Taylor rules than other countries. Maybe somebody's already done that, in which case it would be great to have the reference. Otherwise, as I'll probably run some regressions on that issue over the coming weeks anyway, I will be happy to share the results with your readers.

Macro Man said...

Bureaucrat, if you run some numbers I would be quite intrested in seeing them, so please do share. Of course, the problem is establishing just what the inflation target part of the Taylor rule formula should be: core PCE 1.75%? headline PCE 2.5%? Who knows.

In any event, that they cut 50% in September with a) equities closer to the year's highs than lows, b) GDP in the midst of a 5% quarter
c) the dollar starting to come under pressure, and d) commodity prices rising sharply, promising uture inflation suggests that for the time being, the threshold to emphasize the growth over inflation mandat es was very low.

Anonymous said...

Outstanding post, as usual.

Keith

Anonymous said...

Tend to agree that the record of different governors under various scenarios should have more impact in evaluating the excuse of a "Fed put".

Frankly the mandate is so slippery anyway " long run growth... long run potential....promote effectively ...long-term interest rates." that anything could be done, particularly, in the short term. It has been... and one thinks this flexibility is enjoyed and quite consciously so, with the sides of "the Fed put" box capable of being conjured into appearing and disappearing according to the audiences' willing credulity.

Other equally/more important factors are likely to be:
-the nature and quality of oversight and accountability
-the intellectual make up and influences upon Fed and governors
-political pressures, nature and intensity
-Treasury. Government.
-Reserve currency status
-consequences of policy
-actions coordinated or not of large dollar acquirers of holders

Would less flexibiity be better or work? That is another question.

OldVet said...

Lower US interest rates has led to consumption over savings and investment for years, and now Fed promises more of same. Trying belatedly to prop up employment through lower interest rates is unlikely to work, given lags in fixed investment decisions. Inflation certainly won't disappear with lower rates or lower Dollar.

Mercantilist peggers' inflation problems and high employment choices are inverse policy to Fed's in recent years. If pegger's uncouple somewhat and let currencies strengthen, it's hard to see why Euro would suffer or fall against the Dollar. Stronger currencies equal stronger markets for Euroland exports, offsetting US exports.

Where would Swiss fall in this array of virtuous and vicious as they change roles, potentially? In the Euroland bag, in your opinion?

OldVet said...

Cursed by more imagination than information, I now note MorgStan's Jen calling for massive G7 dollar prop intervention. No wonder dollar showing strength this week.
http://www.morganstanley.com/views/gsb/index.html

Macro Man said...

Anonymous #2, I think that from a purely domestic perspective, the Fed's mandate and its execution has been pretty good, overall. The US is a rich and prosperous country, and some of the cerdit must go to monetary policy-makers. Of course, the US is the world's largest economy and the dollar its most important currency.

I suppose the point that I'm trying to raise here is that the Fed's largely domestic focus is (or should be) broadly incompatible with the notion of the dollar as a store of value, given the inherentlty dilutive nature of Fed policy when compared to that of other CBs. Of course, the obvious rejoinder is that fiat currencies themselves cannot be stores of value per se, and are only worth holding insofar as they can be exchanged for valuable goods/services/assets. Given the breadth and depth of US asset markets, the dollar has indeed commanded a premium. However, now that we live in a world with a viable alternative, the diltuive nature of Fed policy should become a dominant determinant in the dollar's value, as indeed it has done for the past five years.

That having been said, OldVet, I am fairly confident that an end to Bretton Woods II will mean the end of the euro bull trend, for this cycle at least.

Speculative money that has heretofore gone into euros and sterling by virtue of their being 'anti-dollars' (and believe me, we're talking a lot of money here) will almost certainly be re-directed towards erstwhile BWII participants. AT the same time, one would presume that the end of BWII shoul;d to some degree slow the pace of reserve accumulation, and the concomitant price insensitive CB buying. And perhaps most importantly, the euro is approaching (though has yet to reach) the end of its 'easy' rally, when the ECB has desired a tightening of monetary conditions.

Once (and it may be six months away, but it is coming) the ECB desires easier monetary conditions, the euro will come under cyclical pressure. If this comes in the context of BWII dissolving, all the more reason for the euro to fall.

Macro Man said...

OH, and as for the Swiss: Clueless, Helpless, Fruitless pretty much sums up the SNB.

As for Mr. Jen, I think his analysis is misplaced. There is no point propping up the dollar against the €, £, CAD, etc. when it is already being propped up against the RMB, AED, SAR, RUB etc.

Once the buck is tradin g closer to realistic levels against BWII members, THEN it is time to worry about the buck against the others. Not before.

Anonymous said...

MM

Now of course you are asking me to imagine a US economy without the Fed.

Macro Man said...

Au contraire, Anonymous! I'm asking you to imagine a Chinese, Saudi, and UAE (to name a few) economy without the Fed, for verily the Fed cares not about the consequences of its policy on their economy. Not that it it necessarily should, mind you; it just begs the question of why these economies continue to import US monetary policy when it is clearly ill-suited for their domestic needs.

And as for the international investor in financial assets? Well, the dual mandate is right there on the Fed's own website. You cannot say that you were not warned!

HoosierDaddy said...

I think the dual mandate is understandable given the history of the United States Bank(s) beforehand. It might be better to have a more independent central bank with a dual mandate rather than a solely inflation targeting bank that gets dismantled every few years.

Anonymous said...

I am not re: USD so convinced they do not care about "their" economies.

I could be more easily convinced that they do not care now.

t said...

As my previous comment have shown I am no economist. However I do understand feedback and feedback systems pretty well.

With this in mind, you can imagine the Fed as being charged with providing stabilising feedback (in the form of short term rates) to regulate desired measures of economic activity (inflation, GDP growth). The Taylor rule is what we would call simple proportional feedback. The simplest feedback law there is, in fact.

The trouble begins with the measures such as PCE or political dissatisfaction. These are naturally and necessarily lagging the actual state of the economy (which is not directly observed by the measures). So we have a 'closed loop' system of economy and the fed providing the controlling feedback. A system with a time delay and proportional feedback, to summarise. Systems theory easily shows that such systems are not necessarily stable. If the Fed's response lags the right sort of length, and I think political factors encourage it to be backwards looking, the feedback actually becomes destabilising. In this case, the credit binge-and-busts are larger each time. I suspect this is happening.

Arguably this is a case (as perhaps is your excellent post, MM) for a gold standard and a rejection of credit as money, to eliminate any lag and to limit the magnitude of the credit cycle.

Alternatively, and more progressively, a less naive (to this non-economist's mind) feedback rule would be appropriate. Still, tricky job, being the Fed.

RealThink said...

In Louis XVI's France, a few economists (e.g. Turgot), realizing that the state finances were on a crash course, argued that, in order to preserve at least part of the status quo, the nobility had to relinquish some of their privileges (specifically, their exemption from paying all taxes). Their stark advice fell into deaf years and the economists ended up quickly losing their jobs.

On the other hand, most of that time's economists, vying for the nobles' favor and appointments, reassured them that things were working the way they were supposed to, and that there was no need to part with any of the practices that had been established by history. Their soothing advice was welcome by the nobles who, by following it, in a few years had parted with their lands or their heads.

Today, a few economists realize that the US dollar status as the international trade and reserve currency is inherently precarious, arising as it does from its voluntary acceptance by foreigners:


"At present, Americans and non-Americans alike make and receive international payments in dollars because they have confidence that dollars will, relative to other transaction vehicles, retain their value well in future commercial transactions. It is hardly science fiction to imagine a tomorrow in which this is no longer the case."

Benn Steil, Director of International Economics at the Council on Foreign Relations, 2007,
http://www.foreignaffairs.org/20070501faessay86308/benn-steil/the-end-of-national-currency.html
and
http://www.cato.org/pubs/journal/cj27n2/cj27n2-10.pdf

"Falling US interest rates would make the control of inflation even more difficult within the emerging world, eventually increasing the temptation to "go it alone" and leave the dollar to its own destiny. Might this lead to a dollar collapse, a loss of US monetary credibility and the end of an economic pax Americana?

Perhaps this is a fairy-tale too far. ... The story unfolding ... may finish happily ever after. But it might, instead, end up like one of those novels from my namesake, a horrific mixture of weak growth, sticky inflation and, ultimately, a loss of confidence in the dollar's status as a reserve currency."

Stephen King, managing director of economics at HSBC, 2007 Oct 1st,
http://news.independent.co.uk/business/comment/article3015584.ece

What even fewer economists realize is the extent to which life-as-Americans-know-it depends on the US dollar keeping, at least in part, its current privileged status, and the consequences that the complete loss thereof can bring about.

I.e., if the US sticks to its post-Bretton Woods 1 position, and keeps focusing its monetary policy on avoiding internal recessions, regardless of the dollar's external value, countries with current-account surpluses that over the last decade have (out of their own folly) built up huge dollar reserves will be left with no choice but to realize (at long last) that their behavior is most unwise, and change it, at the very least, by stopping their dollar purchases and letting their currencies appreciate against the dollar.

The problem comes if the ensuing fall in the dollar value triggers a chain reaction where dollar holders start to also sell it, the value falls further, and it ends up with the dollar being abandoned as the main international trade and reserve currency. The key point is: if the world's monetary system reaches a final equilibrium state where the dollar is just one more currency in a world of peer fiat currencies, where the only reason to hold it is to pay for exports from the ISSUING country, then the huge amount of dollars (and US-issued dollar-denominated debt) already circulating outside the US ensures that in that final state the equilibrium value of the dollar will be hugely lower than today's. And the impact on US life will be huge too.

I explored this issue in a modest essay at
http://peaktimeviews.blogspot.com/2007/10/realistic-view-of-international.html

The alternative path would be for the US to adopt a monetary policy (and a consistent fiscal policy) geared to preserving the purchasing power of the USD for international transactions by checking the GLOBAL supply growth of the US dollar. Unpleasant recessions may come as a result, but the alternative could be much worse.

Again, in the words of Steil:

"This is the only sure way to keep the United States' foreign tailors, with their massive and growing holdings of dollar debt, feeling wealthy and secure. It is the market that made the dollar into global money -- and what the market giveth, the market can taketh away."

Macro Man said...

Thanks for the interesting and thoughtful posts, guys. I suppose where I come down on the issue is the folloing list of thoughts:

1) The USD has been the predominant global reserve currency because of the unique financial standing, and the depth of asset markets it has produced, of the US economy in the postwar period.

2) This in turn has produced an artifically high demand for both dollars and dollar assets, which has tended to make both artificially strong.

3) The Fed has been directed to conduct monetary policy with a purely domestic focus; given the explicit growth aspct of the mandate, this has been inherently disadvantageous to non-resident holders of dollars.

4) However, in the absence of credible alternatives, foreign reserve accumulators have continue to plow money into dollars/peg to dollars, in spite of the fact that Fed policy has, for al intents and purposes, explicitly ignored their utility

5) As such, the dollar has enjoyed a sort of "foreign reserve seignorage", wherein US borrowing costs have been lower than they would have otherwise been given fundamentals and monetary policy

6) However, the emergence of the euro as a credible alternative has eroded that monetary seignorage that the US has enjoyed; this has been particularly acute aftr the launch of notes and coins in 2002 confirmed the euro as a 'real' currency.

7) That loss of seignorage has not yet impacted Fed policy, primarily because of the loss of seignorage has been RELATIVE, not ABSOLUTE. In other words, while the euro has gained enormous creidbility relative to the dollar, the sheer scale of FX reserve accumulation has meant that the US has continued to enjoy off-market interest rates.

8) Domestic inflation in the economies of mercantilists and oil producers means that they are icreasingly unwilling to pay that seignorage to the US. The final leg of any dollar crisis would presumably entail a large rise in long term interest rates/steepening of the curve as reserve accumulators go on a buyers strke that endures for more than two weeks.

And the ultimate outcome will likely force American hosueholds to alter their behaviour, increase savings rates, and drive smaler cars....just as the 1970's changed behaviour, for broadly similar reasons.

Dr Chaos said...

Arguably this is a case (as perhaps is your excellent post, MM) for a gold standard and a rejection of credit as money, to eliminate any lag and to limit the magnitude of the credit cycle.

With a gold standard, at least in the USA, there certainly was strong instabilities and cycles, because there was still fractional reserve banking.

The gold reserves were, let's say, 'level 0' assets in modern speak, but US dollars were created by individual banks depending on their banker's willingness to lend. (Quite literally, as there were physical currency notes printed and redeemed by individual banks and these had sub $1:$1 market values upon rumors of bank failures).

This meant that a change in attitude---fear replacing greed---resulted in sharp contraction of money supply. And without a counter cyclical central bank (and fiat money), and competitive market forces, the second part of the Wall Street rule ("If you do panic, make sure to panic first!") resulted in strong dynamical instability as well.

In practice, this meant that banks were confiscatory predators in downturns. The hard-nose strictness of the gold standard meant that the banks passed the consequences along to their clients, and hence many loans were callable on demand.

In a systemic credit crunch and given 19th century transportation and information realities, these poor sots had no refinancing alternatives and otherwise productive but long term assets like factories and farms were effectively expropriated-by-tail-fluctuation in a fully legal, open capitalist economy.

There were conspiracy theories, some of which are probably true, that bankers colluded to engineer these at various times to increase their wealth. They empirically appear to have been successful. In the real world, Mister Potter won.

The increase in population and economic growth was incompatible with the realities of gold mining.

And is still today, and we also we know how environmentally damaging and generally stupid an activity it is.

Fiat money is the worst possible form of money until you consider alternatives.

The history of 20th century shows that William Jennings Bryant was right about gold.

The previous poster was also right about time-delay differential equations (!): as a very rough rule, chaos tends to appear very easily (wide range of parameter settings) in such systems versus ordinary differential equations.

A gold standard might reduce the time-delay but it sure puts the instantaneous coefficient into instability faster, during downturns.