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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is a fixed income portfolio manager at Wellington Management
Every five years, the US Federal Reserve plans to update its statement on how it will achieve its dual mandate of maximum employment consistent with stable prices.
The last time the Fed issued this statement was during the Covid-19 pandemic in 2020, when it adopted a framework that focused on an average of 2.0 per cent inflation over time. When the central bank issues its next statement later this year, I believe it should reconsider the dual mandate altogether and reorient monetary policy towards maximising productivity.
Since 2008, annual US productivity growth has slowed to 1.6 per cent, down from 2.4 per cent for the prior 18 years. I believe that a focus on reaccelerating productivity will enable the Fed to achieve the dual mandate’s goals without the negative unintended consequences it has caused, including worsening income inequality and higher debt levels — both of which lower productivity. This trajectory necessitates the dual mandate’s revision.
The Fed’s ability to adjust interest rates to blunt the effects of inflation and unemployment has helped smooth the business cycle time and time again, generating three of the four longest economic expansions in US history since the dual mandate’s adoption. The policy has also afforded the Fed flexibility to step in when needed to prevent severe economic harm, cutting rates dramatically and engaging in quantitative easing to support the economy at any sign of trouble.
But as a result of the likelihood of this policy backstop, the Fed supported a long rise in asset prices. While this is not a problem in and of itself, it has contributed to greater US income inequality, with the top 1 per cent of US households now holding 31 per cent of total wealth, up from 24 per cent in 1990. This has exacerbated other socio-economic challenges such as housing affordability.
The central bank’s willingness to run interest rates at low or negative levels after taking into account inflation also has increased the amount of leverage in the economy. Following the Great Financial Crisis, for example, companies were quick to issue debt and repurchase shares amid negative real rates. The public sector also took advantage to borrow heavily. In both cases, this capital did not do enough to fund investments that increased aggregate supply.
A shift to making increasing productivity the new goal for US monetary policy would inherently support the dual mandate, as a more productive economy can generate stronger growth, improve living standards and support low unemployment, all without increasing inflation. Over time, this should naturally mitigate income inequality and reduce debt levels. While the Fed lacks the means of targeting productivity directly, there are some indirect steps it could take.
The Fed should maintain positive real (inflation-adjusted) yields that incentivise savings over consumption and favour investments that boost productivity and earn a real return on capital, rather than debt accumulation.
And it should refrain from automatically reacting to financial market machinations unless asset price declines or liquidity issues threaten to impede investment growth or bank lending.
While this might seem like a stark change in Federal Reserve policy, this is what they did following the Silicon Valley Bank failure where they continued to raise interest rates, but also temporarily expanded their balance sheet to deal with systemic issues.
How would this fundamental change in framework alter Fed policy from here? Given its progress on reducing inflation, I believe that the Fed should modestly reduce benchmark policy rates but still keep them in positive territory after taking into account inflation. It should also be cautious about reducing or ending its current “quantitative tightening” programme too early. That would risk the progress it has made on inflation.
While the US economy overall has been resilient in the face of recent higher interest rates, this is largely because of persistent fiscal deficits and AI-related spending. Notably, interest-rate sensitive parts of the US economy, particularly manufacturing and small businesses, have struggled. By encouraging companies to invest in capital formation, higher productivity growth should follow.
When the dual mandate was adopted in 1977, it helped restore credibility to an institution that had been blamed for the disastrous stagflation. Nearly 50 years later, however, the negative consequences have multiplied. It is time for the central bank to focus its policy directives on boosting US productivity.