Does the Fed Have the Tool-Set to Achieve Its Dual-Mandate?
Recently, there has been a lot of chatter about the Fed cutting interest rates at a time when unemployment numbers are quite low, and inflation is running just shy of the Fed’s 2% target. Given this dichotomy, I began to question the purpose of the Fed - can the Fed achieve their dual-mandate of stable prices and full employment given their tool set? Well, it depends.
Let’s begin by reviewing the Fed’s goal of “promoting maximum employment and achieving stable prices.” To the layperson, this means full employment and low to moderate inflation. What tool set does the Fed have to achieve these goals? Customarily, the Fed has four main tools:
Discount rate - raising or lowering the discount rate which is the rate at which banks would pay to borrow money from the central bank on a short-term basis. The Fed can indirectly manipulate the federal funds rate, or the rate banks charge each other to borrow or lend funds, by adjusting this discount rate.
Reserve requirements - increasing or decreasing the amount of money banks must hold on deposit at the bank or at a Reserve Bank.
Open market operations - buying and selling U.S. government securities.
Interest on Reserves (additional tool given to the Fed by congress after the recession of 2007-2009) - paying interest on excess reserves held at Reserve Banks.
If the primary tool set of the Fed is comprised of the four items listed above, how does altering the discount rate, reserve requirement, open market operations, and interest on reserves help the Fed achieve stable prices and full employment? Most can assert manipulating these tools would have an impact on prices, or inflation, as each tool can directly or indirectly manipulate money supply which in turn can impact the supply and demand dynamics of pricing power. But how do these tools directly or indirectly influence employment? Altering the employment side of the Fed’s dual-mandate is therefore more difficult and may take longer to observe the ramifications.
Directly, I do not see any way the employment side of the Fed’s dual mandate is affected by their limited tool-set. That said, it is possible the second order impacts of these tools may influence employment in our economy. How you may ask? When the Fed is implementing accommodative policies such as decreasing the discount rate, reserve requirements, the interest rate of reserves, and increasing open market operations, it is referred to as an “expansionary monetary policy.” The opposite would be “restrictive.” When monetary policy is expansionary or accommodative, this should provide businesses the confidence they need to expand. Put another way, when interest rates are low, firms can expand and hire new employees, when debt is readily available at low rates. Bearing in mind that future debts can be financed at a lower rate. Furthermore, expansionary environments may hint the expansion is young and companies have time to hire and foster employees. A restrictive policy may signal the expansion is long in the tooth and a company may find itself overextended if they hire too much.
The question – does it work? Some measure the Fed’s track record, or at least their ability to achieve the “full employment” side of their dual mandate, by observing the unemployment data. Let’s look at the unemployment rate which is defined as the percentage of those in the labor force that cannot find a job and is calculated by the Bureau of Labor Statistics. At present, the federal funds rate (indirectly controlled by the Fed) has been held very low this entire expansion and unemployment numbers are at 50-year lows. Let’s take a look at a graph which observes the relationship between the federal funds rate and the unemployment rate to see if there is a noticeable relationship.
There's a clear trend showing when the fed funds rate is low, employers hire more workers and the unemployment rate declines. The question is – is this causation or correlation? In 2004, the Fed began hiking rates, but the unemployment rate did not increase meaningfully until 2008. At that time, the Fed lowered rates and again, the results were not seen until 2010. Was the move a result of the Fed or merely a reaction to where the economy was in the business cycle? The Fed would say their monetary policies impact employment. In 2007, Federal Reserve Governor, Frederic S. Mishkin, discussed the dual-mandate by stating:
“Maintaining price stability is also essential for achieving the other element of the dual mandate, namely, maximum sustainable employment. First, as I have already emphasized, a low and predictable inflation rate plays a crucial role in facilitating long-term growth in employment and labor productivity. Second, although the economy will inevitably be buffeted by various shocks, in the majority of circumstances the appropriate monetary policy response to stabilize inflation also helps to stabilize employment and output fluctuations around their maximum sustainable levels. In other words, the two elements of the dual mandate are usually complementary.”
A basic explanation of what he is saying that the Fed directly controls inflation and since the two are complementary then the Fed thus directly controls the labor market through the federal funds rate. Taking a look back at the graph I posted earlier, you can begin to see that employment numbers seem to have a lagged response to the fluctuations in the interest rate. We can test this assertion by viewing a chart which compares inflation to the federal funds rate. If the Fed is accommodative to increase employment, the federal funds rate should be decreasing.
In the graph above, you may have expected to see that a low federal funds rate results in higher inflation and vise-versa. This seems to be happening some of the time, but the federal funds rate doesn’t seem to have a meaningful effect on inflation. When the federal funds rate is high, money should theoretically be pulled out of the economy, as banks must pay a higher rate on their short-term debt. This should weigh down inflation. This same inverse relationship happens when the Federal Reserve lowers rates. On the other hand this graph seems to show that the federal reserve rate as well as inflation seem to follow in tandem vs. the basic theory of being inversely correlated.
So now, we have seen the Fed cannot influence inflation or employment directly. Is it possible those two factors influence each other? This brings us to the Philip’s Curve. An economic model showing the historical relationship between unemployment and inflation. Up until this cycle, low unemployment has spurred inflation as a low inflation rate (2% as defined by the Fed) should be representative of a healthy economy, where people spend and increase demand for goods and services, leading to inflation. Is it possible that Mr. Mishkin was correct in his assertions that the Fed controls the inflation rate directly which can then indirectly influence the labor market through demand? The graph below shows the relationship between inflation and unemployment.
Here, we can observe this intuitive relationship between inflation and unemployment until recently. However, this may be the result of external forces and the worst recession since the Great Depression.
Inflation is the result of a healthy economy where businesses can raise prices and productivity is rampant. Workers should be rewarded by their productivity and a business’ ability to raise prices which is the reason wage growth is approximately the sum of these two components (depending on the share of profits the labor force is able to take). With weak inflation and productivity, wage growth has failed to pick up. This creates a perpetuating cycle where the lack of wage growth, makes it difficult for the labor force to spend, creating weak demand for products, holding inflation down. This makes the Fed’s inflation target of 2% (measured by core personal consumption expenditures) seem even further out of reach.
To make monetary policy more complicated, the Fed is currently faced with a problem. Inflation is below their 2% target they set in 2012. Even after the recent rate cut, inflation still seems like a distant dream. Skeptics are doubting the Fed’s ability to navigate these turbulent markets and it’s creating an environment where setting monetary policy is near impossible. The Fed cannot raise rates without beginning to worry about deflationary pressures, and with the dollar being as strong as it is recently these pressures could happen sooner rather than later if the Fed raises rates. The rate is so low there isn’t a lot of flexibility/protection to cut in the case of a recession. What does the Fed do? Well at the most recent Fed hearing we heard Powell announce a fed funds rate cut and that it’s a “mid cycle cut” does this mean that the economy is encountering slack? And the US is entering a new paradigm and will continue expansion for another 10 years? Or is the talk about this being an “insurance cut” true? Despite what Powell has said if we look at it historically, a lot of people would say that in 2008, Bernanke didn’t lower rates soon enough. That the Fed was complacent with the glaring issues in the economy. The Federal Reserve didn’t lower rates in 2008 after Lehman Brothers fell, and money was tight in households due to a low savings rate and slow wage growth, they thought that the worse had come and gone. What they found was that they were wrong in leaving the rates unchanged at 2% and now it seems, Powell doesn’t want to follow in their footsteps. As GDP growth slows down, poor wage growth and poor manufacturing numbers creep in, Powell looks to be taking a more proactive approach then Bernanke in 2008. Will this help us in delaying a recession or possibly make a looming one worse? These external forces do not make the Fed’s job any easier and may cloud the relationship between monetary policy and the Fed’s dual-mandate.
Acknowledging the information above, let’s go back to the original question - can the Fed uphold their dual-mandate with their tool-set? The argument could be made for either side, and I did not thoroughly analyze all the Fed’s policy tools in this paper. What does the Fed do? They have now shown a willingness to lower rates but are saying that we shouldn’t be expecting more rate cuts any time soon. So I guess this means that we will be employing a strategy the Fed was employing before these most recent rate cuts, wait…. and see.
You may have heard economists or pundits on CNBC referring to Federal Reserves Governors as “hawks” or “doves.” The “hawks” are the governors that focus the inflation side of the dual-mandate and the “doves” are the ones that believe full employment is more important. The hawks do not believe they can move directly impact the employment side of the dual-mandate so they advocate we should focus on prices. This leads the group to encourage tightening monetary policy or raising rates earlier than the doves. The doves believe they can directly influence the employment side of the dual-mandate so they promulgate the Fed should hold off on raising rates until the labor market is on solid footing. This usually takes longer to observe. Hence, the reason doves usually want rates low for longer and hawks want to raise rates early to prevent inflation from spiraling out of control. The dichotomy between doves and hawks in the Fed is fertile ground for debates as they must deliberate to determine the appropriate path for the economy. As I discussed above, it is cumbersome to prove the Fed has the ability to influence the employment side of the mandate so the debate of whether to be a hawk or dove will likely continue for years to come. One of the best reasons to be an economist is that it is difficult for someone to prove you wrong. To me, the employment side of the dual-mandate is influenced by fiscal policies and not monetary policies. For this reason, I do not feel as though the Fed has the ability to control the labor market rendering half of the dual-mandate outside of their control. Do you dare prove me wrong? I implore you to try.
To a healthy economy and a continued expansion,
Austin Dilg & Noble Wealth Partners
If you find this topic interesting - check out Episode 5 of The Noble Perspective podcast where Dr. Jim Glenn shares his thoughts about the Federal Reserve and Monetary Policy.