Tuesday, November 16, 2010

The Fed's Dual Mandate

Some Republicans in Congress have come out in support of altering the Fed's dual mandate to focus solely on price stability. The dual mandate is written into the Full Employment and Balanced Growth Act (a.k.a. Humphrey-Hawkins Act) of 1978, which was an amendment to the Employment Act of 1946. Humphrey-Hawkins is behind this statement in the last FOMC statement:
Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability.

Now, what does "fostering maximum employment" mean? Would we have maximum employment when all working-age individuals have a full-time job, when all working age individuals have a full-time or part-time job, when some specified fraction of the working-age population has a full-time or part-time job, when total hours worked exceeds some quantity? If we specified exactly what maximum employment is, would it even be feasible for the Fed to achieve this? What a can of worms!

It is certainly widely-recognized that central banks can control inflation, though of course the short-run connection between central bank actions and inflation can be loose at times. Some central banks in the world that have adopted explicit inflation targeting have achieved some success in conforming to their targets. Generally, it seems that it is feasible for a central bank to keep inflation within some target range, whatever it is, so long as the range is sufficiently broad.

Inflation targeting was first adopted in New Zealand in 1989, and since then the U.K., Canada, Australia, South Korea, and Brazil, among others, have adopted it. We would think of most of these countries as more left-leaning, and with more extensive social insurance than is the case in the United States, so inflation targeting is by no means part of a general right-wing agenda. In the past, many economists, inside and outside the Federal Reserve System, have been proponents of inflation targeting, including Ben Bernanke.

Given the support in Congress for focusing the Fed's mandate on price stability, the time might be ripe for Bernanke to get behind this. This is certainly consistent with things that Charles Plosser (Philadelphia Fed President) has been saying about a new Accord between the Fed and the Treasury. This is an important opportunity for the Fed, and getting on board with an inflation-targeting agreement could also keep the Fed out of trouble (with everyone).


  1. Ragu Rajan in his book Fault Lines argues that US monetary policy tends to put excessive weight on unemployment in the "social welfare function" precisely because of the lack of a safety net in the US. So maybe the US should institute a genuine welfare state like Canada and Australia as well as removing the dual mandate?

    anon of tx

  2. Monetary policy seems like a poor vehicle for the provision of social insurance, including unemployment insurance. I assume your last sentence is a joke. I'm sure some people think this is a good idea, but I don't sense a groundswell of support.

  3. Canada's inflation targets of the late '80s were a catastrophe carried out under a right wing government. The Great Canadian Slump and a new normal of high unemployment resulted. Predictably, the media directed blame at social programmes that were subsequently chopped to pieces and the Canadian business elite yelled at Moody's analysts demanding a reduction in Canada's credit rating.

  4. The original anonymous was arguing that if the policy elite officially declare that there must be a Reserve Army of Labour designed to keep down inflation, and they would be if the Fed dropped the dual mandate, that the unemployed should get better treatment than they get now in terms of a safety net to permit their survival.

  5. "Canada's inflation targets of the late '80s were a catastrophe..."

    News to me. I think the consensus is that inflation targeting in Canada has been a great success.

    "Reserve Army of Labour designed to keep down inflation"

    You think maybe there is a permanent Phillips curve tradeoff? I thought that idea was debunked long ago.

  6. No, as a result of this experiment we had a recession that began six months before everyone else's and escalating unemployment, we had a disaster. This caused a record deficit was used as an excuse to chop up our social programmes... it was the Great Canadian Slump.

    Unemployment was over 10% as the new normal. Right now it's about 8% and they're cheering how wonderful it is, that's how low our standards have dropped! Curse you John Crow! Curse you Michael Wilson! Curse you Brian Mulroney!

    When the central bank kills inflation, it does so by creating unemployment. There is no other way. That's the mechanism it uses. Higher interest rates in and of themselves are inflationary. Demand must be suppressed through forced unemployment to counteract that. The high rates causes bankruptcies, causes business to shed staff and this suppresses demand in general.

  7. Guess what happened to governments that presided over inflation target Canada? The ruling PCP was wiped out - only one PCP incumbent won his seat for a grand total of two seats compared to 170 or so won in 1988. The NDP was severely damaged because two of the most populous provinces were under NDP rule during most of this experiment, most notably Ontario. The media was very good at blaming the Ontario government for things completely out of its control.

    Meanwhile, in Quebec, support for independence reached its highest levels and the referendum almost went for the Yes side in 1995 as the austerity part of the Great Canadian Slump was being implemented. It started with the inflation targets causing unemployment and higher deficits. The deficits were then used to push through austerity. Publications openly compared Canada to Mexico and Argentina. When Moody's refused to downgrade Canada's credit rating, business leaders called up Moody's people screaming at them, ordering them to do otherwise. Quebec nearly separated because of these policies.

  8. Professor,

    I was wondering if you could give some insight as to what academic economists think about economists who use their (former) academic prominence to disguise their selling out. In other words, what are your feelings towards Taylor regarding this letter? Or towards Larry Summers when he says the problem with the economy is too much greed from bankers? Thanks.

  9. Hamed,

    Well, sometimes economists are scientists, and sometimes they are political actors. Sometimes they are both. You have to study their behavior and try to understand which part they are playing and who wrote the script.

  10. Not sure where Anonymous is going. Inflation targeting has worked wonders in Canada and indeed, through the last 2 decades, inflation has been contained within the boundaries set by the central bank about 95% of the time, including now.

    Sure, the 90s were fiscally tough but the outcome was 12 straight years of fiscal surpluses and a current deficit-to-GDP ratio that some countries would kill for. Canada had the courage the U.S. can't afford to have right now.

    The unemployment rate reached a historical low of 5.9% in September 2007 and it now stands at 8%.That's not too bad for a country that's supposedly been through a "disaster".

    Besides, I don't see what the separation question had to do with any of that. The 95 referendum as the culmination of a movement started in the 60s.

  11. 10% unemployment as normal is a good thing? This is the problem with you inflationistas. You fail to consider the real damage these misguided policies cause to people. I grew up in that time and it was extremely depressing. The Great Canadian Slump was extremely damaging to this country.

    You know that these misguided policies caused right wing populism as people were at each other's throats trying to throw the "other" overboard during this time of retrenchment - anyone for a Tea Party? Extremely dispiriting and sad time. Some times I wish Quebec had separated to teach everyone a lesson.

  12. You can go on about how improvement caused partly by Chinese thirst for natural resources supposedly vindicate these policies but a Lost Decade which the '90s was is a lost decade - a long, long, long time of damage to real people.

    By the way, about 2007; we had a socialist budget in '05 because of minority parliaments since '04. Interesting how things improved under minority governments with socialists holding the balance of power. The Conservatives wanted to go Ireland austerity economic suicide in '08 but thankfully the opposition parties threatened to bring down the government. We were saved then from ruin caused by the usual conservatives and their social engineering.

  13. anonymous:

    Not sure where to start with this. You are mostly talking nonsense.

  14. The Fed sees price stability and employment as two sides of the same coin. E.g. to high unemployment for too long causes deflation, while sudden spikes in employment leads to inflation.

    I think their view is something like this: The "natural rate" of unemployment went down to 4.5-5% when inflation was kept under control, so the short-term tradeoff between inflation and unemployment is an illusion--in the long run, unemployment is lower under price stability.