Following the mid-term elections, new legislative priorities will take hold in 2019. By giving Democrats control of the House of Representatives while allowing Republicans to retain their majority in the Senate, voters have, in effect, asked leaders from both parties to compromise in ways that will benefit the country as a unified whole.
One issue on which common ground might be found concerns the Federal Reserve’s “dual mandate,” through which Congress asks the Fed to achieve low rates of unemployment and inflation. For years, economists both inside and outside the Fed have argued that monetary policy could be made more effectively under a simpler mandate that addresses inflation alone. Given the curious economic conditions now prevailing in the United States, it is an ideal time for lawmakers across the political spectrum to consider changing the Fed’s mandate to singularly focus on maintaining a low and stable rate of inflation.
The Federal Reserve Reform Act of 1977 instructs the Fed to conduct monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” This legislation is the source of the Fed’s existing dual mandate, to achieve low rates of unemployment and inflation.
Economists have long recognized the serious flaws in this dual mandate. A full decade before the 1977 Act, Milton Friedman used his 1967 Presidential Address to the American Economic Association to summarize the lessons that U.S. monetary history taught him about what monetary policy can and cannot do. The close connections that Friedman found between money and prices in the data made him confident in predicting that the Federal Reserve could successfully stabilize inflation by allowing for slow but steady growth in the money supply. Friedman also observed, however, that while increases in money growth sometimes lead to increases in employment in the short run, these effects inevitably wear off in the long run, as prices and wages adjust to the change in policy. Thus, according to Friedman, any attempt by the Fed to push unemployment persistently lower would prove futile; the Fed should focus on controlling inflation alone.
In Chapter 2 of a their 2001 book Inflation Targeting, economists Ben Bernanke, Thomas Laubach, Frederic Mishkin, and Adam Posen summarize the economic research that supports and extends the insights from Friedman’s Presidential Address. Repeatedly, both within and across countries, experience has shown that by acting to stabilize inflation first, central banks have not only delivered directly on their promise to stabilize prices, but also created the macroeconomic preconditions that led, indirectly, to robust growth in employment as well. This book remains noteworthy, not only because of its comprehensive review of theory and data that highlight the benefits of a monetary policy strategy built around inflation targeting, but also because of the distinguished positions held by its authors at central banks around the world. Bernanke served, of course, as Federal Reserve Chair from 2006 through 2014; Mishkin held a seat on the Federal Reserve Board from 2006 through 2008; Laubach is presently Director of the Fed’s Division of Monetary Affairs; and Posen was a member of the Bank of England’s Monetary Policy Committee from 2009 through 2012.
The Federal Reserve’s Statement on Longer-Run Goals and Monetary Policy Strategy, first adopted in 2012 and repeatedly renewed since then, attempts to reconcile the wisdom of Friedman, Bernanke, and others with the dual mandate by stressing that while “the inflation rate over the longer run is primarily determined by monetary policy … the maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market.” Through this skillful use of language, the Fed finesses its way out of this fundamental problem: it can – and does – set for itself a specific, two percent target for inflation, but cannot possibly set a similar numerical objective for unemployment. Nevertheless, the foundations for successful monetary policymaking should be set more firmly, through clear statutory guidance, and not based only on the rhetorical abilities of current Fed officials. It would be preferable for Congress to resolve this issue once and for all, by replacing 1977’s dual mandate with a new one focusing on inflation alone.
Why might the new 2019 Congress accomplish this small but important task? The reason has to do with the peculiar – but very welcome – combination of low unemployment and inflation prevailing in the United States economy today. Ordinarily, Democrats in Congress would join with “doves” at the Fed to support more accommodative monetary policies that might work, at least temporarily, to promote job creation. With unemployment now at just 3.7 percent, however, it is very difficult to argue that the Fed should do more to stimulate the labor market. Meanwhile, Republicans usually side with “hawks” at the Fed to argue for tighter monetary policies that keep inflation in check. But while inflation has very recently converged back to the Fed’s two percent target, since 2008 it has run consistently below that target, making it equally difficult to argue that the Fed needs to work harder to suppress inflation.
To explain this curious state of affairs, we only need to recall what Milton Friedman saw in the data many years ago: that unemployment is affected by many factors that lie well beyond the Fed’s control. Today’s very low rate of unemployment surely reflects, in part, the aging of the American labor force, since older workers are far less likely than their younger counterparts to leave or lose their jobs. And low unemployment reflects, as well, a troubling mismatch between the skills that businesses demand and those that potential workers have, which keeps many Americans out of the labor force completely. In the official statistics, these “discouraged workers” are counted as neither employed nor unemployed; hence, the 3.7 measured rate of unemployment overstates the true strength of the labor market. Of course, the Fed also monitors trends in labor force participation to get a more accurate sense of the job opportunities available to all potential workers. But it remains true that these trends in labor force participation, like those in the unemployment rate itself, reflect problems relating to demographics, technological change, and education that Federal Reserve policy cannot possibly address.
Instead, Congress must tackle these problems itself, leaving the Fed to focus solely on inflation. In particular, if inflation falls back below the two percent target, as it has done repeatedly over the last ten years, the Fed will need to pause in its current campaign to raise interest rates, so as not to choke off the ongoing economic expansion. But if inflation climbs beyond the two percent target, the Fed will have to raise rates more rapidly, to avoid a persistent overshoot of the target that would require an even more costly correction later on.
In 2019, Congress could help the Fed focus on what matters most to all Americans – prolonging the economic expansion by keeping inflation low and stable, as close as possible to the two percent goalpost. Congress could do this through a bipartisan effort that replaces the dual mandate with a single goal to stabilize prices alone.
Peter Ireland is a Professor of Economics at Boston College and a member of the Shadow Open Market Committee, an independent group of economists focused on improving monetary policy, organized with the help of the Manhattan Institute and Economics21.
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