By William Poole
President,
Federal Reserve Bank of St. Louis
Global Interdependence
Center (GIC) Abroad in Chile Conference
Universidad Adolfo
Ibáñez
Keynote Address
Santiago, Chile
March
5, 2007
The Federal Reserve Act as amended in 1977
directs the Federal Reserve to pursue monetary policies to achieve
the goals of “maximum employment, stable
prices, and moderate long-term interest rates.” The
Federal Reserve and all central banks have also long been expected to
promote financial stability. Since the 19th century, central banks
have been expected to serve as lender of last resort to the banking
system.
The goals of maximum sustainable
employment and economic growth, stable prices, moderate interest
rates, and financial stability are too often viewed as
incompatible with one another. Conventional wisdom holds, for
example, that if monetary policy is too focused on controlling
inflation, then output and employment growth will likely fall below
their potential and financial markets will be less stable than they
otherwise could be.
............ I do not subscribe to the
conventional wisdom. .................... in my view, price
stability, financial stability and economic growth are mutually
consistent goals for monetary policy. Further, I believe that price
stability must be the paramount objective for monetary
policy because without price stability, the goals of maximum
employment, moderate interest rates and financial stability will be
more difficult, if not impossible, to achieve.
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).]
[
maximum employment,
stable prices, and
moderate long-term interest rates
asset-price targeting in the bond market ]
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."
Posted by Macro Man