The Hidden Third Mandate
The Federal Reserve Act may soon create serious problems for Jerome Powell – or perhaps I should say “Too Late” Jerome Powell, as President Trump has taken to calling him.
Most economists discuss the Federal Reserve’s “dual mandate”—to secure both “stable prices” and “maximum employment”. The Fed has interpreted this more specifically as a 2% inflation target, with room to support employment so long as it doesn’t conflict with price stability.
But here’s the truth: the Fed doesn’t have a dual mandate—it has a triple mandate. The actual language in the Federal Reserve Reform Act, dating from 1977, states that it’s the Fed’s responsibility “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”
There it is – a third goal: to ensure “moderate long-term interest rates”.
This has rarely commanded much attention, as economists generally assume that low inflation automatically leads to low inflation expectations, which in turn ensures moderate long-term interest rates.
When Goals Collide
What’s striking is that the law doesn’t discuss what the Fed should do when these three goals conflict.
There’s now consensus amongst economists (less so in 1977) that monetary policy cannot permanently hold unemployment below the “structural unemployment” rate, and attempting to do so will cause inflation to spiral out of control.
That’s why the Fed has interpreted the law for at least 30 years such that the inflation target takes precedence over the employment goal.
But for the past three decades, there hasn’t been a test of the interest rate goal. What happens when long-term rates begin rising sharply, so we can no longer say they’re “moderate long-term interest rates”?
The Warning Signs Are Flashing
This is hardly a hypothetical scenario. The 30-year Treasury yield today rose above 5%.
This could happen if markets lose confidence in the US government’s willingness and ability to repay its debt. Given how the Trump administration (and previous ones) and both Democrats and Republicans seem utterly indifferent to public debt dynamics, the risk of a sudden and severe spike in interest rates is increasing.
What then?
The Fed could argue that rising rates reflect irresponsible fiscal policy and do nothing. Just as they’ve never assumed “maximum employment” means zero unemployment, recognising structural labour market conditions.
But they’ve only been able to take this position because monetary policy genuinely can control inflation long-term but cannot control unemployment long-term (which is structurally determined).
Interest rates are different. When fiscal policy becomes unsustainable, what economists call “fiscal dominance” emerges – where expectations arise that unsustainable public finances will eventually force the central bank to “rescue” the government by monetising the deficit.
In this situation, expectations of monetisation cause inflation expectations to explode, and it’s fiscal policy, not monetary policy, that effectively determines inflation.
If the central bank attempts to tighten policy, it merely exacerbates the fiscal problem and potentially increases inflation expectations further.
This is typically what happens in countries where massive public finance problems create expectation dynamics leading to hyperinflation.
Thankfully, the US isn’t there yet. But we’re moving in that worrying direction.
The question now is: when can we say the Fed isn’t meeting its “triple mandate”? What if rates rise to 6% or 7%? Or 10%?
The Fiscal Dominance Trap
In that situation, there are certainly good grounds to claim the Fed should buy US Treasuries to push down government bond yields.
But in that situation inflation expectations would explode – and the dollar would weaken markedly. And yes, actual inflation would shoot up dramatically.
The Fed would thus be forced to abandon its inflation target – even though it all stems from irresponsible fiscal policy over which the Fed has no influence.
We see here that economic gravity determines the hierarchy of the three goals.
Under normal conditions, the Fed can focus on ensuring low inflation and, when there’s room, support employment – and interest rates will remain “moderate”.
But if fiscal policy becomes truly unsustainable, the Fed essentially loses control. Expectation formation will completely undermine the Fed’s ability to control inflation. And worse – according to the Federal Reserve Reform Act, it’s actually the Fed’s obligation to ignore inflation (which it can’t control in this situation anyway) and focus on keeping rates low.
Trump’s Dangerous Game
This is an extremely worrying scenario, and one must say it’s becoming increasingly likely given that US fiscal policy is clearly completely unsustainable, there’s no political will to address it – and yes, it’s simultaneously clear that President Trump believes it’s the Fed’s job to solve the problem by cutting policy rates.
President Trump recently suggested that the Federal Reserve should substantially cut policy rates to help lower the mounting interest rate cost associated with servicing the massive government debt. Last week, the president sent Powell a handwritten note: “You should lower the rate — by a lot! Hundreds of billions of dollars being lost!”
Trump hasn’t yet focused on long-term rates, but with continued rises in Treasury yields, it’s surely only a matter of time before he realises the Federal Reserve Reform Act might be used to twist Jerome Powell’s arm.
The conditions for fiscal dominance — when a central bank’s ability to control inflation through monetary policy is effectively negated by a government’s high debt and deficits — are falling into place.
The Independence Illusion
That said, the Federal Reserve Reform Act also guarantees the Fed’s independence, and there are no sanctions in the law against the Fed if it doesn’t meet the “triple mandate”.
What’s frightening, however, is that we even need to discuss these matters, but it would be deeply irresponsible to ignore these risks.
The bond market is already sending warning signals. Moody’s downgraded the U.S. government’s credit rating earlier this year, citing the increasing burden of financing the government’s ballooning budget deficit.
The Price of Recklessness
We’re witnessing the early stages of what could become a full-blown fiscal dominance crisis. The Fed may soon face an impossible choice: follow its triple mandate and facilitate fiscal irresponsibility, or maintain its inflation-fighting credibility and risk being accused of violating the law.
This is the price of decades of fiscal recklessness. And I fear we’re only beginning to pay it.
