Alexander W. Salter
The Federal Reserve has a dual mandate: maintain stable prices and full employment. Central bankers conduct monetary policy to keep inflation low and predictable while promoting strong labor markets.
At least that’s what’s supposed to happen. As we’ve learned the hard way, things work out quite differently in practice.
The Fed dropped the ball in 2008, failing to create a robust recovery. In 2020, its monetary response to the COVID-19 crisis was better, but it came with some very bad precedents in the form of questionable credit-allocation programs. The Fed seems incapable of fulfilling its basic function without creating a host of harmful side effects.
Now the Fed was caught napping amidst the worst inflation in 40 years. While this isn’t entirely the Fed’s fault—supply-side problems are partly responsible for price hikes—monetary policymakers nonetheless failed again at their essential duty.
Given this cluster of major policy errors, we should question whether the Fed is capable of managing its vast policy portfolio. Let’s start by rethinking the dual mandate. The macroeconomic consensus of the past 40 years suggests the employment plank of the mandate is redundant. At most, the Fed can keep prices stable. Asking for more is neither necessary nor desirable.
Macroeconomic health depends on two factors: aggregate demand and aggregate supply. Aggregate demand refers to total spending, which equals total income because in the aggregate, every dollar spent by someone is income for someone else. Aggregate supply refers to general productive conditions, which depend on the effective use of labor, capital, and natural resources, as well as a political-legal environment conducive to commerce.
The Fed has some control over aggregate demand, but not aggregate supply. When the Fed, through monetary policy, keeps overall demand stable, inflation is mild. This is good for labor markets: A stable, predictable dollar makes it easier to write all sorts of contracts, including labor contracts. The way the Fed fosters the labor market is through its monetary powers. There’s no separate channel or link for the Fed to influence employment. Aggregate demand is the only option.
Sometimes economic commentators say there’s a tradeoff between inflation and unemployment. This is false. In the short run, if the Fed runs the printing presses hotter than everyone expects, it may be able to fool some businesses into hiring more workers. But loose money eventually causes inflation: prices rise, and businesses learn what they thought was strong demand for their products was really just a funny-money effect. Labor markets will ease as workers are laid off or have their hours reduced. For given supply conditions, there’s a natural limit to how much policy can boost employment.
Since the Fed can only influence employment through demand stabilization, the employment part of the mandate is redundant at best and misguided at worst. If the Fed is doing its job, keeping inflation under control will foster robust labor markets. If the Fed isn’t doing its job, it gives the Fed an excuse to tinker with parts of the economy best left alone.
Congress should revise the Federal Reserve Act to tighten the dual mandate into a unitary mandate. The Fed’s sole goal should be price stability. While there are better rules on paper than an inflation target, in practice it’s probably the best we can do. The American public understands inflation and policymakers have a reasonable degree of control over it. When choosing a policy rule, we need humility first and foremost. Let’s stop asking the Fed for more than it can deliver.