David Wessel’s Curious Defense of the Fed’s Ambiguous Mandate

David Wessel, the Wall Street Journal’s economics editor, appears displeased that Republican Congressmen Bob Corker, Paul Ryan and Mike Pence want to clarify the Federal Reserve’s mandate – instructing the Fed to focus on preserving the value of its Federal Reserve notes, rather than continuing the 1946 Employment Act’s instruction to also “maximize employment” and minimize long-term interest rates (he mistakenly refers to this as “reopening the Federal Reserve Act,” which included no mandate).    Wessel imagines this must be a political stunt, citing some seemingly sensible comments by Sarah Palin as evidence.  He cannot imagine any valid reason for a prudent backlash against Chairman Bernanke’s repeated references to the dual mandate as an excuse for trying to nudge inflation higher. 

Instead of looking ahead, Wessel looks back – selectively.   He writes, “prices rose at only a 1% annual rate in the third quarter, the Commerce Department said Tuesday.”   However, that figure refers only to personal consumption expenditures (PCE), not to inflation in the overall economy, including producer prices.  The implicit price deflator for GDP rose by less than 1% in 2009, then at a 1.1% rate in the first quarter, 1.9% in the second and 2.3% in the third.  That is insufficient evidence of a worrisome trend, but it is also insufficient evidence to justify a massive program of monetizing long-term Treasury bonds.

Since QE2, Wessel notes, “markets have confounded the Fed by pushing yields on 10-year Treasuries up lately” [to about 2.9% from 2.5%].   I hate say “I told you so,” but I told you so.  

Wessel counters that, “No measure of inflation expectations foresees anything like the 8%-plus inflation of the ’70s.”  Of course not.  If markets expected inflation above 8% then bond yields would already be above 8%.   But expected inflation never makes a sudden leap from 3% to 8% overnight, and expectations are often slow to catch up to reality.  

In 1972, no measure of inflation expectations provided advance warning of the 7.9% rise in the core PCE deflator in 2004 (10.4% including food and energy).  In 1978, no measure of inflation expectations provided advance warning of the 9.2% rise in the core PCE deflator in 1980 (10.7% including food and energy).    Inflation creeps before it gallops.  Yet inflation surprises commonly result in falling bond prices and falling real wages, which means expectations proved overly optimistic.

Mr. Wessel’s new book is called, “In Fed We Trust.”   Such ardent faith has often been misplaced.