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. The Federal Reserve Act of 1977 modified the original act that established the Federal Reserve in 1913 and clarified the roles of the Board of Governors and the Federal Open Market Committee (FOMC).
Congress explicitly stated the Fed's goals should be "maximum employment, stable prices, and moderate long-term interest rates." These goals, which remain today, came to be known as the Fed's "dual mandate." 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 (or full) employment is the total measure of employment that the economy can experience without any overt inflationary pressures. 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 Fed is not tasked with achieving 0% unemployment.
The desired unemployment level prevails in normal economic conditions or the absence of a boom or recession. This is referred to as the noncyclical rate of unemployment (previously known as 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. However, 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 2023. 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%.
Price Stability
People and businesses need to be reasonably confident that prices will remain relatively constant over time so they can plan for the future. As a result, unstable prices (through 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 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.
The FOMC announced it was going to raise the target range for the federal funds rate by 25 basis points during its March 2022 meeting. Rates effectively rose from between 0% to 0.25% to 0.25% to 0.5%. This move was the first rate increase since 2018 and was prompted by higher inflation. The rate has increased since then, with the most recent hike of 25 basis points in July 2023 to between 5.25% to 5.50%.
Can the Fed's Dual Mandate Work?
The Federal Reserve's dual mandate is to achieve maximum employment and keep prices stable. It does this by controlling the money supply, and raising or lowering interest rates when the economy is slowing down or growing too fast.
Maintaining the dual mandate is possible, in theory. But some critics suggest the two ideas clash, saying that maintaining maximum or full employment may be difficult while keeping prices low. Some experts also want the Fed to focus on just one mandate—notably, keeping prices in check.
What Is Monetary Policy?
The term monetary policy refers to tools used by a central bank to control the country's money supply and boost economic activity. In the United States, the Federal Reserve is responsible for implementing and maintaining the country's monetary policy. It entails controlling how much money is available in the economy.
Monetary policy can be contractionary or expansionary. When the Fed contracts its monetary policy, interest rates increase and the money supply is cut back. This is done to curb inflation. Expansionary monetary policy occurs when interest rates are lowered and the money supply opens up. When the Fed takes these steps, it's meant to boost growth when the economy slows down or during a recession.
What Are the Key Responsibilities of the Federal Reserve?
The Federal Reserve is tasked with several main goals. These include setting interest rates, managing the country's money supply, and overseeing the nation's financial markets. The Fed is also responsible for acting as a financial services provider for various entities, including the federal government, banks, and financial institutions outside the U.S. It also manages payment systems in the United States.
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.
