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Fratto: In Light of Downgrade, A ‘Triple Mandate’ for the Fed

Tony Fratto|Managing Partner, Hamilton Place Strategies
Sunday, 7 Aug 2011 | 10:53 AM ET

With S&P’s downgrade of the United States’ credit rating from AAA to AA, many are speculating on how markets and U.S. authorities will respond.

In an excellent post outlining the possibilities, CNBC’s John Carneyoutlines the likely outcomes and policy options – including the role of the Federal Reserve:

  • Making it very clear that the Fed will continue to accept U.S. Treasurys as collateral for every type of transaction, including the discount window.
  • Expanding the balance sheet even further and buying bonds from any "forced sellers."
  • Selling Treasurys if the market responds to a downgrade by rushing into bonds.
  • Bank capital relief: As explained earlier, it’s likely that banking regulators would not require banks to hold additional capital against Treasurys. After all, they’re supposed to be getting rid of ratings requirements altogether.
The Federal Reserve headquarters in Washington, DC.
The Federal Reserve headquarters in Washington, DC.

Over the past year, especially since the Federal Open Market Committee’s decision to restart quantitative easing last year, there’s been a lot of discussion of the Fed’s so called “dual mandate”. But Federal Reserve Act actually says a bit more, requiring the Fed “to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." (emphasis mine)

We forget this last part of the “dual mandate” language because in the macroeconomics, moderate long-term interest rates can only exist with low inflation and price stability. The interest rate mandate explicit in the law is said to be subsumed to the “price stability” mandate, and so we talk of a dual mandate.

In truth, as we’ve grown very comfortable thinking about the Fed’s role in executing monetary policy, we’ve hardly ever contemplated some other factor besides inflation would influence long-term interest rates. We certainly never spent much time thinking about a downgrade.

But if interest rates were to spike because of some externality other than inflation – say, a U.S. credit rating downgrade – the Federal Reserve would have a legitimateresponsibility under the law to use those tools Carney outlined (and maybe others).

And in that case, the “moderate interest rates” language would rise to equal standing with the “maximum employment” and “stable prices” language, forming a newly realized “triple mandate” for the Fed.

Tony Fratto, is a Managing Partner at Hamilton Place Strategies, former Assistant Secretary at the U.S. Treasury Department, and a former White House official. He is also an on-air contributor for CNBC and founder of the policy discussion website rooseveltroom.net You can follow him on Twitter at http://twitter.com/TonyFratto.

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