The need for a price stability mandate.

• Author: Orphanides, Athanasios
• Position: Report

The founding of the Federal Reserve was a good idea, but its performance during its first hundred years has been hampered by the lack of clarity of its mandate. At times its mandate was interpreted as requiring the pursuit of multiple targets resulting in the failure to safeguard price stability over time. This article reviews the evolution of the Federal Reserve's mandate and argues that Congress should clarify die primacy of price stability as the central bank's mandate to ensure that the Federal Reserve will better safeguard monetary stability going forward.

Was the Fed a Good Idea?

Was the Fed a good idea? In one word: "Yes!" This is perhaps the expected answer from someone who spent many years at the Federal Reserve. This one-word answer, however, reflects the more general belief that a well-functioning monetary system is a prerequisite for the greatness of any nation and that a central bank is necessary to safeguard monetary stability in a modern economy. Over the past century, the United States has evolved into the most powerful nation on earth, and the creation of the Federal Reserve 100 years ago has contributed to this achievement. Emergencies may arise where the very existence of a nation could be threatened in the absence of a central bank. During war, the ability of a nation's central bank to facilitate the financing of the war effort may become a matter of existential consequence. During crises central banks can play a critical stabilizing role.

While the creation of the Fed was a good idea, a qualifier is also appropriate: In two words, my answer is "Yes, but." In its history so far, the Federal Reserve has not always managed to avoid major errors. On the 100th anniversary of the Federal Reserve, it is appropriate to focus on what can be learned from the mistakes of the past to improve its performance going forward.

A central bank is necessary to ensure a well-functioning monetary system. But what exactly should a central bank aim to do? How broad should its mandate be? How can it best contribute to the functioning of our economy? Some envision a very broad mandate for the central bank and the discretionary power to seek numerous objectives all at once. Others suggest a more limited role, guided by systematic rules that avoid discretionary actions. Discretion should never be ruled out completely. Crises and emergencies may require actions that deviate from systematic rules. Not all circumstances can be foreseen and neatly captured in systematic rules ahead of time. The relevant questions are: What defines the systematic behavior of the central bank? How clear are its objectives under normal circumstances? and How limited is its discretion during crises?

Despite the best efforts of its dedicated staff and leadership, the Federal Reserve did not avoid serious errors. Why were these errors committed? What was the central bank trying to achieve? Did the Federal Reserve deviate from attempting to attain its mandate and if so how? In my view, an important part of the answer is that the Federal Reserve has been hampered by the lack of clarity in its mandate. At times, its mandate was interpreted overly broadly, overburdening the central bank beyond what any central bank can reasonably be expected to deliver. At times, this has led the Federal Reserve to try to achieve too many things at once and lose sight of price stability, the one objective that a central bank can and should deliver over time.

While price stability is essential for a well-functioning monetary system, the mandate of the Federal Reserve has never clearly specified that it should treat price stability as its overriding objective. This can be corrected. What is required is an Act of Congress to make price stability the primary objective of the Federal Reserve.

An Evolving Mandate

When the Federal Reserve was founded in 1913, the Federal Reserve Act made no mention of price stability and its mandate was rather diffuse. The preamble of the Federal Reserve Act called for the establishment of the Federal Reserve "to furnish an elastic currency." Section 14 of the Act came closest to specifying a policy objective:

Every Federal reserve bank shall have the power: ... To establish ... rates of discount ... which shall be fixed with a view to accommodating commerce and business [Section 14, Federal Reserve Act, 1913],

As the Federal Reserve was founded in the environment of the gold standard, which was thought to safeguard price stability over time, it could be argued that in 1913 it was not necessary to explicitly state that price stability should be the mandate of the institution. The leadership and the staff of the Federal Reserve made efforts toward a more concrete interpretation of the mandate, but the lack of clarity hampered the institution.

In 1939, in the first edition of the Federal Reserve's publication Purposes and Functions, the Hoard of Governors tried to explain its role as follows:

The purpose of Federal Reserve functions, like that of Governmental functions in general, is the public good. Federal Reserve policy cannot be...