The Fed's Conundrum
Is the Dual Mandate an impossible task?
As noted by Jonathan Groff in Hamilton, ruling ain’t easy. The Fed knows this all too well. The Fed has been blamed by some for just about every recession and/or crisis since the Great Depression. Even if many might agree they did a good job putting out various fires or saving the economy from ruin, the critics are always lurking. Typically, that criticism falls squarely on the head of the Fed.
Just ask former chairman of the Fed, Ben Bernanke. Bernanke, a long-time professor of macroeconomics worked his way up the “ladder” at the Board of Governors, culminating in his appointment as chair in 2006 (and lasting until 2014). He oversaw the Fed during the worst financial crisis in decades, coinciding with the worst recession since the Great Depression.
Before that, his research career was devoted to understanding the links between the financial sector, the real economy, and monetary policy. In fact, before the Great Recession he helped write the “playbook” on the type of monetary policy that was employed during the Great Recession (for example, check out these two papers). He was arguably the most qualified person ever to be the chair of the Fed, yet he still is cast as the villain by some.
Bernanke’s successor, the first female Fed chairperson ever, Janet Yellen—also an incredibly accomplished macroeconomist on par with Bernanke—received constant critique and vilification during her tenure (which may be an understatement). Other pilloried figures include former Fed chairman-turned economic Rockstar of the 1990s, Alan Greenspan (chair from 1987 to 2006). No legacy is safe.
Even famous inflation Slayer, Paul Volcker, received criticism in real time. Though his inflation-busting moves during the 1979 to 1982 period leave him almost immune to criticism today.1
The point is, it’s not easy helming the Fed. Current chairman, Jerome Powell, is obviously feeling this heat. Indeed, I have been critical of the Fed in this forum, accusing them of “dropping the ball.”
Yet, to be fair to the likes of Jerome Powell and his ilk, the Fed is charged with an almost impossible task: satisfying a dual mandate.
The Dual Mandate
What is the dual mandate? In simple terms the Fed has to achieve two objectives:
Keep employment stable. This means keep the unemployment rate somewhere around four to five and half-or so percent (more or less). Or, putting it in terms of a minimum standard: avoid bad recessions.
Keep inflation low and stable. This means keep the rate of inflation around 2 percent and make sure it stays within some relatively reasonable range around 2 percent (in practice, the Fed focuses on the “core” PCE index as part of this mandate, where the range might be between one percent and four percent).
Those two mandates are part of the Fed’s job to carry out “Stabilization Policy,” as directed by Congress (discussed in a previous post).
Why do I say this dual mandate is an “almost impossible” task? Because pulling off both at once is very, very difficult in practice.
The Tradeoff between inflation and employment (sometimes)
It is difficult for the Fed to satisfy both parts of the mandate because the very nature of the business cycle makes it so. Recall the relationship between the output gap and the rate of inflation. The rate of inflation increases as a positive output gap widens. As the positive output gap closes, typically the rate of inflation will decline. If the output gap becomes negative, the inflation rate should decline even more and perhaps even become negative (which would be “deflation”).
At the peak of the business cycle inflation will tend to be nearing its highest rate and may continue to increase even as the business cycle turns (for a visual reference of the business cycle, see this previous post). The timing is not “lock-step” as the rate of inflation “lags” the output gap since inflation expectations take time to adjust.
Of course, my description of this process is very general and can vary depending on the time period we are talking about. The magnitudes of the output gap and the rate of inflation—and the timing of these changes—will vary depending on the circumstances. Every recession is different and every economic expansion is different. But this general description is the “gist” or the “quick and dirty” explanation of the relationship.
It is that relationship that makes the dual mandate difficult to pull off in practice. The dual mandate conundrum is as follows:
To squash inflation, the Fed may have to induce a recession.
To stimulate employment, the Fed may end up stoking inflation.
Members of the Fed are naturally hesitant about slowing the economy. They do not want to unnecessarily cause people to lose their jobs. Or, if the economy is already slowing, they are concerned about making it worse. In this respect, the very act of being humans may lead the Fed to treat the two mandates asymmetrically. When the economy is in a recession, it is easy to act aggressively to boost output and employment. But, when inflation is surging, it is not so easy to then slow it down.
Such hesitancy is easy to see the past few months. Last summer there was less concern over the possibility of a weakening economy, yet the FOMC was still hesitant to get “hawkish” on inflation. Around that time, the Fed voiced their view that the increasing rate of inflation was “transitory”—perhaps trying to convince themselves more than anyone. Coming into 2022 the Fed was obviously aware inflation was running wild and that GDP was coming off of a historical year. The prescription with respect to the dual mandate was clear: focus on inflation.
Yet, fast forward to our current existence and concern over a weakening economy now leaves the Fed in the awkward position of needing to stick with their contractionary plans (i.e. planned interest rate increases) in the face of increased macroeconomic uncertainty. If the Fed “tightens” at the same time as the positive output gap is already shrinking, that could obviously make things worse. It is not a stretch to think that current conditions leave Jerome Powell and company hesitant about how hawkish they should be on inflation.
So, where does the dual mandate leave the Fed in 2022?
Some Hope?
Fortunately, the “damned if you do, damned if you don’t” tradeoffs I describe above are not inevitable. The Fed tries very hard to balance the two parts of the mandate; this is what the phrase “soft landing” refers to when talking heads are discussing monetary policy. And, if we look back at the macroeconomy since the early 1990s up to just prior to the Covid-19 pandemic, the U.S. economy is defined by the two longest expansions on record (the 1990s and the 2010s) along with low and stable inflation.2 Along the way, one could argue the Fed pulled off some “soft landings” within that time frame (this article chronicles some of the 1990s experience).
But, “past performance does not guarantee future performance.” With the imperfect nature of forecasts and the constantly changing business cycle, the Fed faces a formidable task. Regardless of whether or not they put themselves in this mess in the first place, I do not envy the choices Jerome Powell and his colleagues at the Fed are currently faced with.
The only mention I could find of any critique of Volcker is here (admittedly I did not search that long).
Obviously, the Great Recession and the 2008 financial crisis occurred in that time frame, too. But at least for now, I am trying to focus on the positive.