Fed Dual Mandate Shows Bernanke’s Model Working Better in Crisis

Federal Reserve Chairman Ben S. Bernanke
Ben S. Bernanke, chairman of the U.S. Federal Reserve. Photographer: Andrew Harrer/Bloomberg

Federal Reserve Chairman Ben S. Bernanke’s focus on full employment and price stability is being validated as the U.S. expansion gains speed and his counterparts in Europe emulate his approach.

Bernanke pursued new stimulus last year to create jobs, defying critics who said his record accommodation would spark inflation. Now, with U.S. growth accelerating and the euro area on the brink of a second recession in three years, Bank of England Governor Mervyn King and European Central Bank President Mario Draghi are showing they also are willing to spur their economies while inflation exceeds their goals.

“The Fed’s been a success at preventing a catastrophe” from reoccurring after the credit crisis, said Mark Gertler, a professor at New York University who has co-authored research with Bernanke. “Originally, central banks came about to prevent the debilitating effects of financial crises, so I view the dual mandate as the Fed doing its historical job.”

The U.S. is forecast to grow at a 2.3 percent rate in 2012, according to the median estimate of 70 economists in a Bloomberg News survey. That’s almost eight times faster than the 0.3 percent expansion the ECB predicts for the euro region.

Bernanke’s focus on growth “has helped signal to the markets that if we have temporary blips in inflation, the Fed isn’t going to go crazy and try to stabilize the price level at any cost to the economy,” Gertler said.

After completing $600 billion of bond purchases last June -- which unleashed the harshest political backlash in three decades -- Bernanke took additional easing steps in August and September, even though the personal-consumption-expenditures price index rose 2.9 percent in each of those months, the fastest in about three years.

Rising Unemployment

The Federal Open Market Committee, which begins a two-day meeting in Washington tomorrow, acted after unemployment began rising in April, following its decline to 8.9 percent in March from 9.8 percent in November 2010. In August, when joblessness was 9.1 percent, the Fed pledged to keep interest rates near zero until mid-2013.

In September, U.S. policy makers decided to replace $400 billion of short-term debt in their portfolio with longer-term Treasuries, in an effort to lower borrowing costs even more and combat rising risks of a recession.

“Having the dual mandate makes it easier to justify additional stimulus when overall inflation news is relatively high,” said Dean Maki, chief U.S. economist at Barclays Capital in New York. “It’s an easy argument to make that the unemployment rate is too high and our job is to move it down.”

After the Fed’s actions, unemployment fell to 8.5 percent in December, the lowest in almost three years.

‘Ben’s Big Gamble’

Some economists who showed skepticism about Bernanke’s record stimulus measures now acknowledge they seem to be working. Steven Bell, chief economist at hedge fund GLC Ltd. in London, raised questions about the efficacy of Bernanke’s policies in 2008 in a report entitled “Ben’s Big Gamble.” While Bernanke was “laughed at” then for aggressively cutting rates, the policies have helped, Bell said.

“When the history is written of the global financial crisis, Bernanke’s reputation will be incredibly high,” said Bell, a former U.K. Treasury official who studied under Bernanke at Stanford University in California. “He’s displayed extraordinary leadership.”

Bernanke has succeeded so far in warding off a surge in prices. The PCE index rose 2.5 percent for the 12 months ending in November, down from September’s 2.9 percent, and inflation expectations show investors anticipate that the Fed will achieve its longer-run goal of 1.7 percent to 2 percent.

Falling Break-Even Rate

The break-even rate for five-year Treasury Inflation Protected Securities, the yield difference between the inflation-linked debt and comparable maturity Treasuries, was

1.69 percentage points on Jan. 20. The rate, a measure of the outlook for consumer prices over the life of the securities, has fallen from 2.47 points on April 29.

Since Draghi took over as ECB president Nov. 1, he has cut its benchmark twice, returning it to a record low 1 percent as he predicts a “mild” recession in the 17-nation economy. The central bank also has sought to jump-start its financial system so it better transmits the easier monetary policy. It eased in December collateral rules it imposes on emergency loans and handed banks an unprecedented 489 billion euros ($632 billion) in cash for three years in an operation it will repeat next month.

Unlike the Fed, the ECB is mandated to deliver price stability, which it defines as headline inflation running at just below 2 percent in the medium term. The Maastricht Treaty, which created the euro, says the central bank can keep rates low if policy makers judge that price stability is guaranteed.

‘Harmonious and Balanced’

“Without prejudice to the objective of price stability,” the ECB “shall support the general economic policies in the community with a view to contributing to the achievement” of goals including “a harmonious and balanced development of economic activities,” according to the treaty.

The inflation rate was 2.7 percent in December, slowing from 3 percent the previous month and the lowest since August. The ECB predicted in December that inflation will average about 2 percent this year and 1.5 percent in 2013.

Asked Jan. 12 if the ECB is open to cutting rates further, Draghi said it depends on the inflation outlook. JPMorgan Chase & Co., Barclays Capital and UBS AG are predicting the ECB will reduce its benchmark to 0.5 percent by the middle of the year.

“If you look at the recent behavior of the central banks that don’t have an employment mandate, they sure act like they have one,” said Robert Eisenbeis, a former research director at the Federal Reserve Bank of Atlanta who’s now chief monetary economist for Sarasota, Florida-based Cumberland Advisors. “These are unusual and uncharted times.”

Support Growth

The mandate for the Bank of England is to “maintain price stability” and “subject to that,” support the government’s growth and employment objectives, according to the Bank of England Act.

Even with that directive, and an inflation target of 2 percent, the Bank of England resisted raising rates last year from a record-low 0.5 percent as consumer-price growth soared to

5.2 percent. While three of the bank’s nine policy makers voted for an increase, King said at the time that the surge was temporary and attempting to bring inflation back to the goal quickly “risks generating undesirable volatility in output.”

In October, the bank announced 75 billion pounds of government-bond purchases, after buying 200 billion pounds between March 2009 and early 2010. The new program is due to end early next month, and some policy makers have indicated more may be needed.

Fed’s Focus

Bernanke’s approach hasn’t been without controversy, and some Republicans want the Fed to focus solely on price stability. Representative Kevin Brady of Texas, the top Republican on the Joint Economic Committee, said last month that he’s drafting legislation to give the Fed a single mandate.

“This financial crisis really has raised a legitimate question: What is the role of the Fed?” he said in a December interview in Washington. The debate is happening “not just among lawmakers but among the public as well.”

While the Fed’s stimulus efforts have so far failed to cause the surge in inflation predicted by its critics, a too-high unemployment rate may make it more difficult for the U.S. central bank to tighten monetary policy when price stability is threatened, according to Eisenbeis.

“The potential problem of the dual mandate is on the exit side,” he said. Raising interest rates “becomes more difficult if you’re sitting on an unemployment rate that people feel is far from the objective.”

‘Treacherous or Treasonous’

The criticism of the Fed has extended to the presidential campaign trail, with Republican candidates Mitt Romney and Newt Gingrich saying that they wouldn’t keep Bernanke, whose four-year term expires on Jan. 31, 2014, as Fed chairman. Rick Perry, who suspended his campaign last week, said in August that additional stimulus measures from Bernanke would be “almost treacherous -- or treasonous,” and “we would treat him pretty ugly down in Texas,” where the Republican is governor.

The criticism is “raw politics,” as the Fed’s dual mandate has “worked pretty well” and led to stable inflation, Gertler said. “The Fed isn’t trying to fine-tune the real economy, it’s trying to prevent things from falling off a cliff.”

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