The past few weeks have seen the Fed struggle to define a clear exit route from its forward guidance strategy. Ambiguous macroeconomic data have triggered different interpretations by prestigious board members, leaving markets with little clue as to future Fed moves.
These discussions, sometimes going as far as confrontations, are a byproduct – a healthy one in our opinion, – of the US institutional framework that assigns to the Fed the dual objective of stable inflation and high employment. Why are discussions that perturb markets healthy? And what is the relationship between them with the central bank’s objective?
A dual mandate requiring the central bank to pursue two, sometimes conflicting, objectives forces the institution to make inherently political choices. Far from being a shortcoming, this allows for a more flexible and unbiased monetary policy. A central bank following a dual mandate will always be able to take an aggressive stance on inflation, if it deems this necessary.. Appropriate choice of the weights given to employment and inflation would allow incorporation of any combination of the two objectives.
The Fed under Chairman Paul Volcker embarked on a bold disinflation programme in the early 1980s, when the US had just adopted this dual mandate. No choice of weights, on the other hand, would allow a central bank following an inflation-targeting mandate to explicitly target employment as well. Thus, the dual mandate can embed inflation-targeting strategies, while the converse is not true. In terms of policy effectiveness, therefore, the dual mandate is a superior institutional arrangement.
Inflation-targeting central banks, such as the ECB, de facto also target growth but timidly and without explicitly saying so. This leads to low reactivity and opaque communication, hampering in turn the capacity of central banks to manage expectations and effectively steer the economy. A good case in point is the ECB that – compared to the Fed – did “too little and too late” from 2009, amid a constant debate on whether the inflation-targeting mandate was being violated.
One may argue that the cacophony currently characterizing the Federal Reserve Board is hardly positive for the economy and that, in terms of managing expectations, lately the Fed did not excel. This is undeniable and is the result of the Fed groping for a way out of unprecedented policy measures. The difference with the ECB is that for the Fed any opacity results from an ongoing debate on how best to attain an objective that is clear and shared. We are not there yet, but the debate will eventually lead to an unambiguous (and hopefully appropriate) policy choice. On the contrary, ECB opacity is intrinsically linked to the confusion between its mandate and its activities in the real world, and as such it cannot lead to any meaningful discussion but only to legalistic disputes on the definition of price stability, of how medium is the medium term and the like.
The main merit of a dual mandate is in fact that it lets the political nature of monetary policy emerge without ambiguities. It is indeed true that monetary policy with a dual mandate requires hard choices, just like those debated these days, and hence is political by its very nature. The point is, so is monetary policy with a simple inflation-targeting objective. The level of inflation targeted, and the choice of the instruments to attain it, is anything but neutral in terms of its consequences on the economy. Thus, an inflation-targeting central bank is as political in its actions as a bank following a dual mandate, the only difference being that In the former case the political nature of monetary policy is concealed behind a technocratic curtain.
The profound justification of an exclusive focus on price stability can only lie in the acceptance of a neoclassical view in which virtually powerless governments need to make little or no choices. Once we dismiss that platonic view, monetary policy acquires a political role, regardless of the mandate it is given.
We do not argue that there would be no issues with the adoption of a dual mandate for the ECB. The institutional design should be carefully crafted in order to ensure that independence is maintained, and accountability (currently very low indeed) is enhanced. What we are saying is that after seven years (and counting) of dismal economic performance, and faced with strong arguments in favour of a broader central bank mandate, EMU policy makers should be engaged in discussions at least as lively as the ones of their counterparts in Washington. So far, however, all is quiet on this side of the ocean…