The Fed’s Dual Mandate Is Outdated

(Bloomberg Opinion) -- Most everybody seems to be wondering what’s happened to U.S. inflation and why it hasn’t returned in any meaningful ways as suggested by the economic models. The answer matters to the Federal Reserve’s unique status as a central bank with a rare “dual mandate” of maximum employment and stable prices.

The evidence is mounting that this dual mandate is clouding the Fed’s judgment, especially at a time when the relationship between inflation and employment is being openly questioned. Congress has changed the mandate before, and maybe it should do so again. Perhaps Congress can give the Fed a mandate of full employment and financial stability, or a mandate of low inflation and financial stability. But juggling employment and inflation at the same time is becoming more and more problematic.

For the current dual mandate to work, the Fed needs a unifying theory so a change in monetary policy affects the mandate the same way and by the same amount. Without a unifying theory, a change in monetary policy is mired with conflicting and contradictory outcomes when trying to satisfy two goals at once.

To find a unifying theory, the Fed turned to the Phillips curve developed by economist A.W. Phillips in a 1958 paper, which says that inflation and unemployment have a stable and measurable inverse relationship. That is, low unemployment causes inflation.

The Phillips curve has been controversial from its inception. Today’s version revolves around a seminal paper on the subject in 1999 written by current Fed Vice Chairman Richard Clarida that suggests the link between inflation and unemployment still exists and is so strong that the Fed can target inflation alone and the employment mandate will also be satisfied. The Fed added a 2 percent inflation target in January 2012.

Evidence that the Phillips curve thinking is still prevalent at the Fed can be found in last week’s Federal Open Market Committee minutes:

Many participants indicated that, while inflation had been close to 2 percent last year, it was noteworthy that it had not shown greater signs of firming in response to strong labor market conditions and rising nominal wage growth, as well as to the short-term upward pressure on prices arising from tariff increases.

The Fed is getting the message that their theory is not working, so they are holding a series of “Fed Listens” meetings which end with a research conference on June 4-5 in Chicago. As they explain:

With labor market conditions near maximum employment and inflation near its 2 percent objective, now is a good time to consider whether the strategic framework for monetary policy could be improved and is sufficient to meet challenges that could arise in the future.

Kudos for the Fed to ask the questions. But will it really change? Former Fed Chair Janet Yellen was unmoved in September 2017:

Federal Reserve Chair Janet Yellen acknowledged that the fall in inflation this year was a bit of a “mystery” but suggested that the central bank was on course to raise interest rates again in 2017 nonetheless.

And as Bloomberg News reported, the current Fed thinking is tweaking but not abandoning the Phillips curve.

While Powell has ruled out increasing the 2 percent goal, he’s raised the possibility that the central bank could adopt a “make-up” strategy when it concludes its review in the first half of 2020.

While that could take various forms, at its simplest it would involve the Fed seeking to achieve an average 2 percent inflation rate over the economic cycle. That would mean undershoots of the target when times were bad would be offset by overshoots when times are good, as they are now.

Could it be that the Fed is afraid to abandon a linkage between inflation and growth because they are unable to accomplish the dual mandate without it? And if they do acknowledge the relationship is not there, are they opening themselves up to the withering criticism that they have been creating recessions to eliminate an inflation potential that never existed?

Earlier this year Janet Yellen and former Fed Chairman Ben S. Bernanke acknowledged that the Fed creates recessions to stop what the central bank thought was about to be “out of control” inflation:

I don’t think that expansions just die of old age. Two things usually end them. One is financial imbalances and the other is the Fed, and usually when the Fed ends an expansion, it’s because inflation has gotten out of control and the Fed needs to tighten to bring it down. — Janet Yellen, January 4, 2019

But as Janet says, expansions don’t die of old age. I’d like to say they get murdered, instead. — Ben S. Bernanke, January 4, 2019

Congress passed the Federal Reserve Reform Act of 1977 more than 40 years ago, establishing the current dual mandate, promoting effectively the goals of maximum employment, stable prices, and moderate long-term interest rates. This made sense in the pre-digital/information-age economy, but now with inflation muted even as unemployment pushes 50-year lows, instead of seeking to understand new relationships, the Fed seeks to hold on to a unifying theory to meet mandates established in the Carter administration. It’s time for Congress to give the Fed new mandates that make sense today.

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Jim Bianco is the President and founder of Bianco Research, a provider of data-driven insights into the global economy and financial markets. He may have a stake in the areas he writes about.

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