Exploring the importance of central bank mandates

Central banks around the world carry out monetary policy according to their mandate. But what is not known to many is that this comes with a huge responsibility of juggling or balancing their goals during unique economic environments.

What is the mandate of the US Federal Reserve?

The US Federal is a “dual mandate” central bank. Its Federal Open Market Committee (FOMC), the committee responsible for setting the Fed’s monetary policy, decides 1) maximum employment and 2) price stability, as stated in the Federal Reserve Act. The US Fed does so by using a variety of policy tools to manage financial conditions through conducting monetary policy.

Maximum employment is thought to be the highest level of employment that is economically sustainable over. Measuring this concept can be difficult because the level of maximum employment varies over time with business conditions, demographics, labor market regulations, and other factors.

Meanwhile, price stability means that inflation is low and stable over an extended period. At this stage, people do not have to worry that high inflation will erode their money’s purchasing power. Stable prices also mean consumers and businesses do not have to worry about unpredictable price hikes or falls when setting their capital or operational budgets, or when borrowing or lending money.

Is there a third mandate?

While it is not explicitly mandated, the US Fed does have a 3rd mandate, that is to have moderate long-term interest rates or financial market stability.

In the aftermath of the 2008 Global Financial Crisis, the Fed looked at monetary policies that are very accommodating. This was intended to help lower the highest unemployment rate in recent history. The injection of massive amounts of cash into the US financial system helped in stabilizing a runaway inflation and boosting markets. The Fed’s infusion of cash was translated by investors to minimize financial market volatility, raise asset prices, and create a wealth effect for the purpose of increasing consumer confidence and fostering growth.

Policy remained from 2010 and well into the COVID-19 pandemic. In fact, the Fed’s aggressive action in their quick return to the zero percent interest rates and expanded Fed buying programs showed how strongly the Fed believed in the importance of financial market stability to mitigate the effects of economic dislocations.

Why does the third mandate matter?

More than a decade later, recent events surrounding the banking sector reminded us again how big of a role it plays in the economy and the financial markets. In the aftermath of Silicon Valley Bank’s failure and the contagion fears that followed, the Fed suddenly lost the luxury of focusing on fighting inflation. The Fed and other central banks must juggle inflation and financial stability mandates.

The Fed managed this by dialing down its March policy rate hike by 25 bps to the 5% despite the constant presence of a strong labor market and high inflation, as well as reaffirm the stability of the US banking system. Their language also changed from “ongoing increases” to “additional policy firming,” suggesting a less aggressive policy path ahead. The markets interpreted this as a dovish hike in response to the banking crisis and Fed Funds Futures quickly repriced to a pause at this level followed by a cut in June, a much lower path compared to where it was in February.

What can we learn from here? Whether or not the bank seizure is a lagged effect from a year of aggressive Fed rate hikes and related bond market losses, the Fed needs to do less of the heavy lifting and consider the impact of any further interest rate hikes on the stability of the financial system.

In the meantime, global central banks continue to juggle inflation and financial stability, which is causing a surge in volatility that may also result in more economic problems down the line.

What about the mandate of the Bangko Sentral ng Pilipinas?

The Philippines is also affected by global economic movements, including the policies set by the Fed. Nevertheless, the Bangko Sentral ng Pilipinas (BSP) promises to keep its mandate, which “is to maintain price stability conducive to a balanced and sustainable growth of the economy and employment. It shall also promote and maintain monetary stability and the convertibility of the peso.”

Currently, the inflation target of the BSP is 2%-4%.

How has the BSP fulfilled its mandate?

BSP Governor Felipe Medalla has repeatedly reiterated that the Philippine central bank will continue to be data dependent–a phrase known to many. In the past, we were more or less sure what the next policy rate decision would be–another increase, decrease or a pause.

Now, the BSP has made it clear that monetary action will depend on data. That is monetary action will be carried out to ease persistent price pressures. Although month-on-month inflation has been stabilizing, Governor Medalla said the BSP is confident the downward trend would continue until it reaches its 2-4% target by October.

Governor Medalla also reassured the markets that the BSP’s policies have been supportive of economic growth. Future decisions will be guided by their assessment of the latest information. The BSP is confident that further monetary tightening can be done without risking financial stability as Philippine banks are well-capitalized amid the recent turmoil in global financial markets.

(photo courtesy of US Fed website)

GERALDINE WAMBANGCO is a Financial Markets Analyst at the Institutional Investors Coverage Division, Financial Markets Sector, at Metrobank. She provides research and investment insights to high-net-worth clients. She is also a recent graduate of the bank’s Financial Markets Sector Training Program (FMSTP). She holds a Master’s in Industrial Economics (cum laude) from the University of Asia and the Pacific (UA&P). She takes a liking to history, astronomy, and Korean pop music.