A long, quiet struggle has been going on at the U.S. Federal Reserve under the surface of the country’s political consciousness. It gets mentioned from time to time in the media, but seldom does it get explained with any clarity for average followers of the news and hardly anyone pays much attention. Indeed, it seems largely ignored now as President Obama struggles with his task of choosing the next Fed chairman. But, with Harvard professor Larry Summers out of the running and Fed Vice Chairman Janet Yellen the new frontrunner, this quiet struggle may be heading into a significant new phase.
The struggle is focused on how the central bank deals with its so-called dual mandate established by the Full Employment and Balanced Growth Act of 1978, otherwise known as the Humphrey-Hawkins Act (or HH). This legislation set for the Fed the corollary goals of maximum employment and price stability. The problem is that these goals often are in conflict. An ardent pursuit of price stability, for example, can damage national employment prospects, as happened in the 1980s when Fed chairman Paul Volcker squeezed rampant inflation out of the economy at the cost of a serious recession. Similarly, many people believe the current Fed chairman, Ben Bernanke, is generating future inflation with his rampant money-generating policies called "quantitative easing," designed to address the country’s persistently sluggish job market.
This trade-off conundrum is at the heart of all Fed policymaking, and hence the president’s looming selection of a new Fed chief could have profound consequences on the direction of the country’s monetary policy. And yet the coverage hasn’t focused much on this aspect of the matter.
The New York Times informs us that there were tensions between Yellen and Gene B. Sperling, head of the National Economic Council, when both were advisers to President Bill Clinton in the 1990s. She has clashed also, the Times wants us to know, with Daniel Tarullo, a Fed governor with ties to the Obama camp. But the paper doesn’t tell us what those tensions were about, which renders them meaningless. The Times says that Yellen, as a professor at the University of California at Berkeley, "attacked the dogma of efficient markets" and advocated market regulation, which tells us a little more (though some might quibble with the idea of efficient markets being a "dogma").
The Times article adds that she played a central role "in shaping what has become the conventional wisdom that central banks, for the sake of job growth, should seek to moderate rather than eliminate inflation." This sentence betrays a level of journalistic carelessness bordering on ignorance. First, no one of consequence has advocated a target of zero inflation; second, in today’s world of low inflation, the issue isn’t whether to moderate it but whether to juice it up and by how much; and what is described here certainly does not represent any conventional wisdom, in part because it doesn’t make sense and in part because the Humphrey-Hawkins debate is ongoing and is not in any way settled.
So let’s review this Humphrey-Hawkins conundrum as a way, perhaps, of understanding what’s at stake in Obama’s decision. Even before passage of the 1978 legislation, members of the Federal Open Market Committee, the Fed group that makes decisions on interest rates and money supply, grappled with the contradictory aspects of the dual mandate. In one FOMC session, Fed Governor Henry Wallich said, "If you contemplate what Humphrey-Hawkins implies, if anybody abroad thought this would be taken seriously, we would be disavowing all our anti-inflation effort." Volcker, then Fed vice chairman, replied, "Well, I agree with that." He added, "It seems to me that we are in a very awkward position."
Then President John Balles of the San Francisco Fed suggested a fresh way of looking at it. After all, he said, "inflation does cause recession, and recession causes high unemployment. Therefore, if you want to avoid high unemployment, you avoid high inflation. High inflation, high interest rates, and high unemployment go together and vice versa." As Daniel L. Thorton, vice president and economist at the Federal Reserve Bank of St. Louis, explained in a trenchant analysis in a St. Louis Fed publication, "In effect, [Balles] suggested that the FOMC could argue that they were promoting low unemployment by pursuing price stability. This became a common explanation of how the FOMC fulfilled its dual mandate—by pursuing price stability, it was simultaneously pursuing maximum sustainable employment."
In this way, writes Thorton, the Fed generally finessed the "awkward" situation created by Humphrey-Hawkins and kept the Fed focused primarily on the function for which it had been established in 1913—to maintain a stable currency with a guaranteed value. Thus, it concentrated on price stability first and foremost and argued that this concentration in and of itself fulfilled the dual mandate. For years following passage of HH, in FOMC discussions and in congressional testimony, the central bank avoided direct mention of the dual mandate and even supplanted the concept of economic growth for the legislation’s mandate of maximum employment. The reason: nobody could say how the Fed’s policy tools could actually bring about full employment with any consistency at all. Indeed, according to Thorton, the FOMC didn’t use the term "maximum employment" in a policy statement until December 2008. In reviewing FOMC discussion transcripts from the late-1980s, Thorton concluded, "Hence, the FOMC appears to believe it could achieve the employment aspects of HH’s dual mandate by its price stability objective, just as President Balles had suggested a decade earlier."
But in the 1990s, a number of prominent academic economists became members of the FOMC, and they took a more liberal view of the dual mandate, more in keeping with the views of the legislation’s sponsors, Minnesota Senator Hubert Humphrey and California Representative Gus Hawkins. These new members included Princeton’s Alan Blinder, Laurence Meyer of Washington University in St. Louis—and Janet Yellen. They rejected the idea that the Fed could achieve maximum sustainable output, and hence enhance employment numbers, by simply maintaining price stability. In a 1995 FOMC discussion reported by Thorton on whether the FOMC should adopt a formal numerical inflation objective, Blinder declared, "There is no existing evidence—and I can’t say this too strongly—that having such targets leads to a superior trade-off." Yellen was a bit more direct when she argued that "when the goals conflict…a wise and humane policy is occasionally to let inflation rise even when inflation is running above target."
Thus did the era of the Balles finesse come to an end—and the era of the Fed’s long, quiet trade-off struggle begin. Thorton emphasizes that nearly all participants in this struggle acknowledged over the years that the preeminent long-term goal of monetary policy must be price stability, as that is the only thing the Fed can really control over the long term. But short-term policy became a matter of ongoing contention. An interesting FOMC debate emerged during the years of Alan Greenspan’s Fed chairmanship, when Fed governor Edward Gramlich suggested that the central bank adopt benchmarks for economic performance. Greenspan responded, "I think we have to be a little careful here because there is a prerequisite to this discussion that we don’t talk about, namely how much can we rationally expect monetary policy to do. If we believe that monetary policy has the capability of affecting the economy incrementally in all sorts of ways…then I can see announcing very explicit target levels. My problem with that type of policy commitment is that it promises far more than monetary policy has the capacity to deliver..."
Fed policy under chairman Bernanke, in the wake of the Great Recession of 2008, has sought to do what chairman Greenspan said monetary policy can’t do. The results have been decidedly mixed, with the jury still out on the future inflationary pressures that might now be lurking as a result. But it’s worth noting some realities that Fed officials and Fed watchers of old understood in their bones: inflation is governmental thievery. It’s when the government saps the wealth of its citizens by eroding the value of their money, savings, pensions, municipal or corporate or treasury bonds, and T-bills. It is the scourge of savers, investors and creditors. It is the great boon to debtors. And who is the greatest debtor in the world? The United States government. This is a government, by the way, that is in league these days with the big banks of Wall Street, to which the Federal Reserve seems to direct its warmest and most urgent protective instincts.
The question that should be on Obama’s mind—and the American people’s as well—is how the president can ensure that the Fed strikes the right balance between price stability and economic growth in the crucial next phase in this anemic but perhaps quickening recovery. As the Wall Street Journal editorial page noted the other day, sooner or later the Fed will have to raise interest rates, and the pressure to delay will be enormous. The pressure to delay could be particularly problematic if it is coming from within the Fed itself.