Fed Chairman Bernanke testifies in Congress today, for the first time in front of a Republican controlled lower house. Despite the news value, this invigorates a debate about the Fed mandate that is relevant in the current world context. The Fed has a dual mandate: price stability and full employment. The European Central Bank (ECB) has a simpler mandate: price stability. Most independent central banks in the world fall into the euro-model. In theory this is a very important difference, and to a large extent in practice as well.

The Fed has shielded itself in the dual mandate when criticized as doing more than what it should, when critics say that it is doing the job of the Treasury or at least bailing it out. It is the dual mandate that could allow the Fed to let inflation help solve the fiscal problem when and if inflation increases to the 3-5% area. Clearly, it is the dual mandate that allowed the Fed to play such a strong role in capital markets not only during the crisis but also today by buying securities to accelerate the recovery. Without the dual mandate, interest rates would most likely be higher, the dollar stronger, and the fiscal gap could be a bigger problem sooner.

On the other hand, the ECB should not be able to, and has for the most part stuck to its single mandate by increasing rates when inflation creeps up, even against what politicians would argue were moments of a weak-ish economy. However, the euro emergency has pushed the ECB to steer away from its mandate when it started buying debt of the countries in trouble within the EU. It is this most recent deviation by the ECB that makes the difference between the two models less drastic. If the ECB were to return to its core principles as the euro crisis abates and other resolution mechanisms are implemented, the differences between the euro and the dollar would become relevant again.

Bernanke is right now being questioned by Republican Representative Paul Ryan, who is one of the most eloquent critics of the dual mandate, pushing for a strong dollar and a quick fiscal adjustment that would improve the fiscal backing of the currency. Though there is no real chance of a change to that mandate in the short-term, we believe this is a very important debate. We disagree with those that see these congressional hearings as an intromission into the independence of the Fed. True that it does affect the Fed’s incentives, as it shows some in congress are focused on price stability and would not accept the dual mandate as an excuse for tolerating inflation in the mid single digits. We continue to believe inflation in the 3-5% area is still a possible ingredient of the policy mix of the next 3-5 years. However, debates like the one today reduces that probability.

This is not a theoretical point, but a very relevant policy debate with implications for monetary and fiscal policy, which will directly affect the value of the dollar vis-à-vis its G7 counterparts. The value of the dollar relative to other strengthening currencies is already a trend that would only change with a surprisingly strong change in the US fiscal position and growth path. As we have said many times, the dollar is not any currency. Being the reserve currency of the world (as well as the main trading currency, etc.) implies the US has more leeway in its fiscal path. At the same time, its history shows the capacity to improve its fiscal stance in a relatively short period of time. For the time being we only see debate, speeches and reports, without much real action towards a serious fiscal adjustment (except at the state level, where spending cuts are happening). We believe Europe is showing that a fiscal adjustment can be stimulative when your credibility is at stake. We hope the US follows on that example.

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