President-Elect Donald Trump can have an immediate effect on U.S. monetary policy by nominating two candidates to fill vacancies on the Federal Reserve Board. Within our system of checks of balances, however, it is members of Congress, not the President, who make the laws. Regardless of whom President Trump chooses to fill the vacant Board seats, our legislators can pave the way for significant and lasting improvements to monetary policymaking strategy. They can do this by giving the Fed a single mandate: to stabilize prices in the long run.
To understand the behavior of U.S. monetary policymakers and to acknowledge fully the sources of both their successes and failures, it is important to recognize that the Federal Reserve was created in 1913 by an act of Congress and has, since that time, been assigned by Congress a shifting array of goals and duties. In particular, for almost forty years now, going back to the late 1970s, the Fed has operated under a legislated dual mandate: to promote both full employment and stable prices.
This dual mandate is deeply flawed in a number of ways. Starting with the most basic, it ignores a fundamental principle of macroeconomics: the classical dichotomy. The classical dichotomy distinguishes between two types of aggregate variables. Real variables are measured in physical units of inputs to or outputs from productive activity. Nominal variables are measured in units of U.S. dollars.
As real variables, employment and unemployment are influenced by a multitude of factors relating to the operation of the labor markets, chiefly technological, regulatory, and demographic developments that affect how many employees firms wish to hire and how many individuals choose to enter the labor force. Monetary policy can influence, but never completely control, the rate of unemployment. By contrast, as a nominal variable, the aggregate price level or inflation as its rate of change is determined in the long run by the Fed and the Fed alone.
No other institution in our economy besides the Fed has the power and authority to take actions that have a lasting influence on the money supply and, through that channel, the dollar price of all goods and services. By ignoring the classical dichotomy, the dual mandate takes an objective that the Fed cannot possibly achieve on its own – maximizing employment – and uses it to distract from a goal that the Fed must achieve by itself – stabilizing prices.
Instead of the classical dichotomy, the dual mandate is based on another key idea from macroeconomics: the Phillips curve relationship associating higher inflation with lower unemployment. The view of the Phillips curve that underlies the dual mandate, however, is also deeply flawed.
Modern macroeconomics has its origins in work by Edmund Phelps and Milton Friedman on the natural rate hypothesis in the 1960s and by Robert Lucas and Thomas Sargent on the rational expectations hypothesis in the 1970s. All of this research emphasizes that the Phillips curve represents a statistical relationship, linking periods of faster-than-expected inflation with periods of lower-than-expected unemployment, that does not offer monetary policymakers an exploitable trade-off between those variables. Later on in the 1970s, Finn Kydland and Edward Prescott built on this idea, showing instead that by deliberately creating inflation in an effort to reduce unemployment, monetary policymakers will succeed only in the former, leaving the economy with higher inflation while providing no benefits in terms of new jobs created.
Kydland and Prescott’s message should be understood as a positive one. It implies that by acting decisively to stabilize inflation first, the Federal Reserve creates the preconditions most favorable for maximal employment as well. Members of Congress can draw on this insight, explaining to public that, under the Fed’s strengthened commitment to price stability, more robust and stable growth in employment will follow.
One doesn’t have to go back decades to find evidence of the incoherence that the dual mandate brings into the monetary policymaking process. The disappointingly slow recovery of the U.S. economy from the 2007-09 recession surely reflects factors – again, technological, regulatory, and demographic – that lie outside the Fed’s influence or control. The extent to which insufficiently accommodative monetary policy is also to blame is reflected, not in the exceptionally low 4.6 percent rate of unemployment that currently prevails, but in the fact that inflation has run consistently below two percent for much of the period since 2010.
Has enough monetary stimulus already been applied, through years of low interest rates, to bring inflation back to its long-run target? By giving the Fed a single mandate to stabilize prices, Congress would help sharpen monetary policy debates to focus on clearly articulated questions like this one. A newly legislated single mandate would thereby do much more to improve monetary policy outcomes than any small set of appointments to the Federal Reserve Board.
Peter Ireland is a professor of economics at Boston College and a member of the Shadow Open Market Committee.
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