Rethinking the Federal Reserve’s Dual Mandate
October 13, 2015
By Shane Murphy, C’17
The theory behind raising interest rates is that in a strong economy with high levels of growth, output, and employment, keeping rates low could lead to runaway inflation. As borrowing becomes cheaper, people borrow more, which leads to more economic growth in consumer spending and, through the mechanics of supply and demand, higher prices for goods and services. The Fed’s goal is to balance the tradeoff between growth and inflation, but the mechanisms through which it accomplishes those goals, and the heuristics used to set policy, bear heavier scrutiny than they have received.
The Dual Mandate
Congress mandates two principal policy objectives for the Federal Reserve: maximum employment (an indication of consumer prosperity) and stable prices (i.e. controlled inflation). British macroeconomist AW Phillips formalized this concept with the development of what has come to be known as the Phillips curve, an economic phenomenon positing that – at least in the short run – central banks face a relatively stable tradeoff between inflation and unemployment.
The theoretical underpinnings of relationship between interest rates and the Phillips model are relatively simple to understand. When Federal Reserve rates are low, it becomes very easy and cheap for companies and individuals to borrow money. This injects more liquid money into economic markets. Companies flushed with cash hire more people, and people who now have more money spend more on goods and services. Thus, unemployment goes down and wages increase.
If demand for goods and services in the economy outpaces the rate at which companies can produce output, excessive demand leads to higher prices and, therefore, inflation. This is known in economics as demand-pull inflation.
At the same time, when unemployment is low, it is easier for people to find jobs. The threat of being able to move to a better job gives employees more leverage over their employers in wage negotiations, and they demand higher pay. When wages go up, the costs companies face to produce goods subsequently increase – since labor is such a large factor of the production process. As a result, companies raise prices. Facing higher prices for goods and services, workers demand even higher wages to compensate, leading to an upward spiral of wages and prices. Economists call this cost-push inflation.
Re-thinking Economic Health Metrics
In short, the Fed is raising rates because it believes that the economy is healthy enough that if it does not rein in the money supply, demand-pull or cost-push factors could cause rampant price inflation. In theory, this makes sense. But in practice, there is almost no empirical evidence supporting Chairwoman Yellen’s thought process.
The best evidence supporting a rate increase is the unemployment rate. As the graph below indicates, the US’s current unemployment rate is slowly converging upon its natural rate, which is the Fed’s estimate of the maximum level of employment achievable with stable price inflation.
But looking past unemployment, the Fed’s argument begins to fall apart. Other factors indicating that inflation is a major worry are basically nonexistent. The economy is still well below its natural rate of output, which is the Fed’s estimate of the maximum level of output achievable with low inflation. Wage growth is nonexistent, meaning that lower unemployment is not actually leading to higher wages and thus excessive demand or rising factor costs. Consumer spending as a percentage of GDP is flatlining, indicating that demand is hardly outstripping supply. And lastly and most importantly, inflation itself is well below target levels. The Fed targets a two percent inflation rate, but the Personal Consumption Expenditures price index – its favorite inflation gauge – remains well below that target, and has consistently remained low for the past three years.
Unfortunately, what all of this shows is that the metric used by the Fed to justify a rolling back of the expansionary monetary policy that stimulated economic growth and employment levels – the unemployment rate – is cherry-picked, specious, and economically misleading. Yes, unemployment is decreasing, but much of that is due to workers leaving the workforce, or taking part-time jobs when they want to be working full-time, or anti-unionization efforts giving bosses more leverage in wage negotiations. So unemployment is falling, but for the wrong reasons, making it an extremely poor gauge of the health of the US labor market.
Resultantly, the Fed needs to reevaluate the extent to which it is fulfilling its dual mandate. Chairwoman Yellen’s comments indicate she believes the organization should focus on the latter aspect – price stability – apparently having already achieved maximum employment. Experientially, however, the case is the opposite: inflation is low and shows little sign of picking up since demand is not outstripping supply and factor costs remain stagnant. The labor market, on the other hand, remains weak, a weakness disguised by a misleading unemployment rate.
Therefore, a rate increase at this time will only hurt consumers and workers as borrowing money to pay for consumption and hiring will become more expensive and difficult. The only winner in this scenario is the financial sector, for whom higher interest rates on loans leads to higher profits on lending.
The Federal Reserve should be working to help all Americans, not just bankers. Rates should stay at zero until the economy shows signs of a recovery that is more than skin deep.
 Josh Clark, “Why does the Fed change the interest rate?” HowStuffWorks, http://money.howstuffworks.com/fed-change-interest-rate.htm.
 Paul R. La Monica, “Yellen still thinks Fed will raise rates this year,” CNN Money, July 15, 2015, http://money.cnn.com/2015/07/15/investing/federal-reserve-janet-yellen-house-testimony/.
 Federal Reserve Board, “What are the Federal Reserve’s objectives in conducting monetary policy?” Board of Governors of the Federal Reserve System, updated June 17, 2015, http://www.federalreserve.gov/faqs/money_12848.htm.
 “The Phillips Curve,” Economics Online, http://www.economicsonline.co.uk/Global_economics/Phillips_curve.html.
Jim Clifton, “The Big Lie: 5.6% Unemployment,” Gallup, February 3, 2015, http://www.gallup.com/opinion/chairman/181469/big-lie-unemployment.aspx.
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