Let’s lower the stakes by asking less from the Fed. Price stability is enough.
Everyone knows the Federal Reserve has a dual mandate: maintain full employment and stable prices. But what everyone knows just ain’t so. The Fed has a third mandate that never gets mentioned: achieve moderate long-term interest rates. The political stakes of this neglected plank are likely to become much higher than today.
The 1977 Federal Reserve Reform Act created the modern Fed’s triple mandate. After more than a decade of chaotic inflation, which finally abated during the 1980s, economists, policymakers, and financial commentators implicitly agreed that the Fed should pursue interest rate stability indirectly. Central bankers interpreted “moderate interest rates” to mean whatever rates were consistent with the Fed’s price stability and employment goals, which were widely believed to be more important and more controllable.
The “gentlemen’s agreement” of subordinating interest rates to jobs and prices may soon come to an end. The federal government will likely run huge deficits for the next ten to 20 years, pushing up borrowing costs. The Congressional Budget Office projects a deficit of $1.9 trillion in 2025, rising to $2.7 trillion in 2035. Federal debt held by the public would rise to 123 percent and 135 percent of GDP, respectively. Real interest rates have risen in recent years and, given Uncle Sam’s increasing demands for scarce capital, will likely continue to do so.
Not everyone anticipates rising interest rates. In fact, the market consensus expects gradually declining rates. Strong global demand for Treasury debt could push down yields. But these rosy projections could fail. If they do, the Fed will be in an uncomfortable position. And even if the projections are right, government borrowing costs will remain well above economic growth. That means the debt will grow faster than our ability to service it. There are few attractive policy solutions to this problem. Nevertheless, it does create difficulties for the Fed. Can interest rates be “moderate” if they result in us mortgaging our national future?
The Fed is already getting involved in fiscal matters. Fed Chair Jerome Powell has assailed our “unsustainable” national debt and called for taxing and spending reform. Some worry that with such comments, the Fed has waded into dangerous waters. Yet Fed concerns about Uncle Sam’s fiscal capacity can be justified by an appeal to the interest rate plank of its mandate.
For better or worse, the Fed’s interest rate duties are the law of the land. The only reason for the Fed not to talk about fiscal policy is the tacit consensus of monetary policy experts that price stability and employment matter more. But that isn’t what the law says. Nobody elected these experts, and they don’t make the rules. The Fed is within its rights to alert the nation to the consequences of spending beyond its means.
Of course, President Trump and his allies in Congress may view the Fed’s fiscal opinions as an unjustified excursion into politics. If so, their retribution would be severe. While the Fed obviously needs reform — 40-year-high inflation during the summer of 2022 was absolutely the Fed’s fault, no matter what its cheerleaders assert — the last thing America’s economy needs is an open spat between fiscal and monetary policymakers.
The solution is to kill two birds with one stone: Give the Fed an off-ramp from fiscal concerns by narrowing its mandate. Remove the employment and interest rate planks; focus the Fed on stable prices alone.
The same arguments that show that the Fed can only promote moderate interest rates by stabilizing prices also show that the Fed can only promote employment by stabilizing prices. By keeping total spending on goods and services on a steady path, the Fed does as much as it can for both labor markets and capital markets. Keeping the dollar’s purchasing power predictable is really all that monetary policy can do. Any law that asks for more is a bad law. Central bankers can’t pick and choose which laws to follow, but that doesn’t mean we should keep counterproductive rules on the books if we can change them.
While the Fed is necessarily accountable to political authorities, we don’t want a politicized Fed. But that may be unavoidable given the law. We can’t have interest rates be a part of the Fed’s mandate and then complain when Fed officials take unpopular positions on the deficit or anything else that affects interest rates. Let’s lower the stakes by asking less from the Fed. Price stability is enough.