Does the Fed need a new mandate?

January 3, 2013

Are the world’s top central bankers too paranoid about inflation? As the United States struggles to sustain a weak recovery while the euro zone and Japan face outright contractions in output, a number of economists have called for the monetary authorities to be less dogmatic about adhering tightly to low inflation targets.

Most prominently, IMF chief economist Olivier Blanchard has argued the Federal Reserve’s 2 percent inflation target is too low given the severity of the loss of employment and growth that followed the Great Recession of 2008-2009. Kenneth Rogoff, co-author of an oft-cited study of economic downturns following financial crises called “This Time is Different,” has also championed greater inflation tolerance.

Fed officials, including Chairman Ben Bernanke, have flatly declined to entertain the notion, arguing that the potential cost – a loss of hard-won inflation-fighting credentials – is too high. “We are not seeking higher inflation, we do not want higher inflation and we’re not tolerating higher inflation,” he told a February hearing in Congress.

Despite such resistance, economists at Morgan Stanley say there is a fundamental contradiction in keeping a singular focus on inflation at a time when households are trying to pay down debt.

Central bank mandates in the advanced economies – such as the Fed’s dual mandate of “stable prices and maximum employment” and the ECB’s primary objective “to maintain price stability” – were designed for an era that bears little resemblance to the one we live in now. In the pre-crisis period, central banks had a tough enough job of trading off current growth against the prospect of future inflation. Now there is the added dimension of (public and private sector) deleveraging that leaves central banks trying to solve an impossible puzzle: To ward off inflation, they would have to be (demonstrably) willing to hurt growth. But by doing so, they would hurt the deleveraging process twice over – once through disinflation and once through lower growth, which might introduce outright deflationary risks.

That disconnect, argues Morgan Stanley economist Manoj Pradhan, requires a change in the Fed’s mandate that recognizes this reality.

It is central banks’ current mandates that pit them against this impossible puzzle, and that these mandates therefore need to change. In our view, this would enhance rather than hurt central bank credibility.

Until private and public sector debt become sustainable, we believe that monetary policy will have to choose higher inflation over the risk of derailing growth and deleveraging. Tightening policy to fight inflation, at least from the major central banks, would create ripples not just domestically, but across the globe.

The impact of monetary tightening when the debt sword of Damocles looms overhead was adequately showcased in the 2011 episode when the ECB tightened policy to try to fend off inflation risks. Higher interest rates pushed the euro economy into recession and aggravated the sovereign debt crisis, with well-known global repercussions. Further, in the current fragile situation where the global economy is stuck in a twilight zone between expansion and recession, tighter global monetary conditions could put the transition of emerging markets to more sustainable drivers of growth in question.

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