Breaking Down the Federal Reserve’s Dual Mandate
4 min read
The U.S. Federal Reserve’s mandate was shaped in the 1970s. This was a period that experienced simultaneous high inflation and unemployment, a condition known as stagflation. Modifying the original act that established the Federal Reserve in 1913, the Federal Reserve Act of 1977 clarified the roles of the Board of Governors and Federal Open Market Committee (FOMC).
Congress explicitly stated the Fed’s goals should be “maximum employment, stable prices, and moderate long-term interest rates.” It is these goals that came to be known as the Fed’s “dual mandate” and remain today. In this article, we explore all three facets of the central bank’s mandate by first looking at maximum employment before turning to the other two goals, which can effectively be treated as a single mandate.
Key Takeaways
- The Federal Reserve’s two mandates were shaped in the 1970s.
- The first is to maintain maximum employment and the second is the keep prices stable while and long-term interest rates at moderate levels.
- Rather than trying to reach 100% employment, maximum employment means keeping it at levels that are seen in normal economic conditions when there is neither a boom nor a recession.
- Stable prices and moderate long-term interest rates are deemed one mandate.
- Long-term interest rates are set with an eye to managing pricing pressure and inflation.
Maximum Employment
Maximum employment is also referred to as full employment. It is the total measure of employment that the economy can experience without ushering in overt inflationary pressures. As such, almost everyone who wants a job can secure one during maximum employment. The goal, though, isn’t to reach 100% employment and completely eradicate unemployment. That’s just not possible.
Economists know there will always be some level of unemployment. People will always quit and start new jobs, businesses will fail and new ones will be set up, and specific sectors will contract and expand. Because it takes time to find a new job, there will always be a certain level of unemployment. As such, the level the Fed is tasked with achieving is not 0% unemployment.
The desired unemployment level is one that prevails in normal economic conditions or in the absence of a boom or recession. This rate is commonly referred to as the noncyclical rate of unemployment—previously called the natural rate of unemployment). It is determined by structural factors that affect the flexibility or mobility of the labor market. For example, regulations that restrict labor mobility tend to raise the natural rate. But allowing individuals mobility to work in other regions can effectively reduce the natural rate of unemployment.
It is not always obvious whether the economy is in normal economic times or even where the noncyclical rate of unemployment falls. Thus, the Fed must rely on assessments from its members despite the uncertainty, and these are always subject to revision. The longer-term natural or normal rate of unemployment is estimated to hover around 4.4% during 2022. That estimate drops to about 4.3% as the economy heads into 2030.
The U.S. Federal Reserve made revisions to its inflation target in 2020 to an average, meaning that it will allow inflation to rise somewhat above its 2% target to make up for periods when it was below 2%.
Stable Prices and Moderate Long-Term Interest Rates
People and businesses need to be reasonably confident that prices will remain relatively constant over time so they can make plans for the future. As a result, price instability in the form of either deflation or rapid inflation can have drastic consequences on economic stability.
As noted above, ensuring stable prices and moderate long-term interest rates could effectively be interpreted as a single mandate. That’s because long-term nominal interest rates are set with inflation expectations in mind. For any given nominal interest rate, rapidly rising prices diminish the real interest rate that lenders receive and debtors must pay. Thus, in an unstable monetary environment with rapidly rising prices, lenders will want to charge much higher interest rates to mitigate the inflation-rate risk.
The FOMC began targeting inflation at 2% in January 2012 in order to achieve its dual mandate. This was just after combining the goals of stable prices and moderate long-term interest rates into a single one. As such, many see this as the Fed’s attempt to be consistent with the single mandate of price stability sought by the European Central Bank (ECB).
By ensuring price stability, the Fed reasons that this inflationary target creates a stable economic environment that can foster the goal of maximum employment. When prices are stable, people and businesses can make longer-term economic decisions necessary for stable economic growth. This leads to improved employment opportunities.
During its March 2022 meeting, the FOMC announced it was going to raise the target range for the federal funds rate by 25 basis points. Rates would effectively rise from between 0% to 0.25% to 0.25% to 0.5%. The move, which was the first rate increase since 2018, was prompted by higher inflation.
The Bottom Line
Whether it is a triple, dual or single mandate, the primary aim of the Federal Reserve is to create a stable monetary environment. To achieve this, the Fed has deemed that targeting inflation (by keeping it at a low and stable rate of near 2%) is the best way to achieve such stability. So all the fuss about changing interest rates is really all about keeping prices stable in order to foster economic growth and promote maximum employment.
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