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The case for a 'dual mandate' Samuel Brittan Financial Times 11/04/08 The world's main central banks have lived up to their reputations. The US Fed is throwing everything it has into its attempts to stimulate the US economy. The Bank of England is following a policy of stately and gradual relaxation, restated in Thursday's interest rate announcement. The European Central Bank is staying put and stresses the inflation threat. The obvious explanation for these discrepancies lies in the economies for which these authorities are responsible. The US is almost certainly already in recession, even though it may take the authoritative National Bureau of Economic Research several more months to declare this fact. The UK economy was still growing at only slightly below trend rates in the first quarter, even though the shakeout in house prices has put the fear of God into the headline writers. The eurozone is still performing relatively well, but the inflation rate has crept up to 3½ per cent compared with a target of just under 2 per cent. A minor benefit from these discrepancies is a respite from lectures on the superiority of the Anglo-American model. There are, however, other factors involved, notably a difference in the mandates under which these institutions work. The Fed was enjoined under the 1978 Humphrey Hawkins Act to co-operate with the administration to achieve full employment and price stability. The act itself expired at the turn of the century and some ridiculously ambitious targets enshrined in it were quietly forgotten years before. But both the Fed and Fed watchers still accept the idea of a "dual mandate" for both growth and price stability. It is thus hardly surprising that the US has had in most of the past few years an inflation rate of about 3 per cent, marginally higher than the eurozone or even the UK, but with no tendency to run away unless the externally generated 4 per cent registered so far this year is regarded as a portent. At the other extreme the "primary objective" of the ECB laid down in the statute establishing it is to "maintain price stability". It has to support the general economic policies of the European Union, but only "without prejudice" to the price stability objective. Similarly, the Bank of England's monetary policy committee is required to pursue the government's 2 per cent target for the consumer price index and "subject to that to support the government's objective of maintaining high and stable growth and employment". As in every period of economic stress there is no lack of alarmist voices saying that "the old rules no longer apply" and that monetary policy has become ineffective. What is true is that lower nominal interest rates on their own, at a time when investment sentiment is depressed, work by promoting net exports through currency depreciation or by stimulating consumer borrowing. Clearly not all currencies can depreciate against each other; and there are arguments against restarting the consumer borrowing spree which helped to trigger the present troubles. Interest rate cuts, combined with fiscal stimulation, do not carry quite this risk. Governments in, say, the Group of Seven industrial countries are hardly likely to default. The fiscal rules that limit budget deficits in most countries are very necessary to prevent a long-term debt trap, but should surely be shelved if the world, or parts of it, faces the worst slump since the Great Depression - as many assert but which I still doubt. A more highbrow criticism of the dual mandate is that one instrument, namely nominal interest rates, cannot be used to determine two objectives - growth and price level behaviour. And it is indeed true that if a central bank simply shifts from one to the other according to the political pressures of the moment it is likely to ratchet up inflation with no lasting offsetting gain to growth. This is roughly the story of the pre-Volcker Fed. There is a way of combining the objectives which avoids this trouble, namely to target what economists call nominal demand, but which may be simply translated as internally generated cash spending. It is then left to economic agents to determine how far this is reflected in real growth and how far dissipated in inflation. If nominal demand is rising by 5 per cent per annum - just a shade below what has been achieved in the UK since the early 1990s - and inflation is zero, growth of up to 5 per cent can be financed. But if inflation is 5 per cent this becomes a ceiling even at the cost of zero growth. Faithful readers might remember that I used to plug this objective, but gave the topic a rest when inflation targets alone seemed to be doing the trick. In those days I put it in terms of a nominal gross domestic product objective, mainly because a few people had heard of it. But a gross domestic expenditure target is in principle superior, partly because it leaves room for an improvement in the balance of payments, should that be necessary. The inflation component of either measure corresponds roughly to domestically generated inflation, the case for which I put a fortnight ago. A nominal demand objective might also take us nearer to the position in the gold standard years when price stability was achieved over a period of decades, but allowed large variations in year-to-year inflation rates.
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