Saturday, December 21, 2013

Does the Federal Reserve Need to Continue with Its Dual Mandate?

Ever since 1913, the Federal Reserve, which is the central banking system in America, has been responsible for the country's monetary policy. The Federal Reserve has evolved and expanded its role over time. Presently, the Federal Reserve's role can be summarized in its "dual mandate" of maximizing unemployment and stabilizing prices. Given the power of "lender of last resort" that the Federal Reserve has been delegated, it makes me wonder whether permitting the Federal Reserve to have two mandates is too burdensome.

The dual mandate originated when the Phillips curve was popular. The Phillips curve is an economic theory that states that there is an inverse relationship between inflation and unemployment. The higher the increases in real wages, the lower the unemployment, and vice versa. This does not seem to make intuitive sense because if a group of people went to ask their employer for double the wage, many would be out of a job. Even so, the Phillips curve had some decent empirical backing, at least until the stagflation of the 1970s. Ever since, the correlation has been questionable, to say the least (see Figure below from the Richmond Federal Reserve). I would theorize that monetary policy had something to do with the breakdown of the Phillips curve in the long-run because prior to the severance of the connection between gold and currency, prices were pretty stable. Regardless, Janet Yellen, the impending Chairwoman of the Federal Reserve, still believes in this relationship and that it should dictate policy.

Let's assume this correlation does not exist and that the non-existent correlation does not provide a carte blanche to fine-tune deficits and government spending where we can maximize employment without high levels of unemployment. Let's also assume that the Fed should drop one of its mandates. Which mandate should it drop?

There is next to no evidence that the Fed can affect the unemployment rate. If there were a link between unemployment and monetary policy, the link would not show up immediately because the effects of monetary policy are long-term. Also, there are multiple factors that determine the unemployment rate, including taxation, regulation, and fiscal policy, that make it exasperating to determine the net effects. The more probable culprit is in the labor market, which is something the Fed cannot control with monetary policy. Considering that market conditions vary from state to state, it becomes even more difficult to implement a "one size fits all" solution. Using the unemployment rate is not an absolutely sound metric, either. The unemployment rate can be dropping because more people have jobs. However, when considering the labor participation rate, it can mean that the U-3 unemployment rate dropped because more citizens left the labor market discouraged (see U-6 unemployment rate). Also, let's take a look at how well the Fed has handled its unemployment maximization mandate:

Multiple rounds of quantitative easing have not helped with unemployment reduction. The Fed seems to have better success with price stability than with employment maximization (see CPI from Bureau of Labor Statistics), although let's not confuse correlation with causation. This non-relation between monetary policy and employment would explain why Congress has attempted to amend the dual mandate (H.R. 245) by reducing it to a single mandate of price stability. Even former Fed Chairman Paul Volcker agrees with a single mandate. Doing one thing well is preferable to two half-hearted policies. However, as the Congressional Research Service (CRS) brings up in its research of the dual mandate, as long as the Federal Reserve is given discretion to dictate monetary policy, it really doesn't matter whether there is one or two mandates (p. 23). I disagree with the CRS because the Fed is using the unemployment rate as a metric for success, which is unwise since monetary policy does not really affect the employment rate. If the Fed is going to have a mandate, it should focus on metrics it can influence, which means the dual mandate should become a single mandate.

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