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The Fed: Dual Targets Or Dueling Targets?

Contributed by Raymond James

The Federal Reserve has adopted an inflation target, as many other central banks have done long ago. However, the Fed retained its dual mandate, with a soft employment target. How will the two goals be achieved and what happens when they conflict? The Fed says is will use a balanced approach.

The Fed lengthened the period for which it expects to keep short-term interest rates at exceptionally low levels (now, “at least through late 2014”). However, the five Fed governors and 12 district bank presidents have differing opinions on when the Fed should start raising short-term interest rates and what the appropriate level of the federal funds rate target will be at the end of 2014. There was closer agreement on where the federal funds rate target is expected to be over the long run (a 2% inflation rate + a 2.0-to-2.5% premium = 4.0-4.5%)

The Fed will now shoot for a 2.0% annual rate in the PCE Price Index, which is similar to the CPI, but adjusts for changing patterns of consumption. The 2.0% goal would allow for more effective monetary policy during recessions. Other inflation-targeting central banks have a similar goal. For the Fed, a 2.0% inflation rate is “price stability.”

The Fed also is required to achieve maximum sustainable employment, which “stands on an equal footing with price stability as an objective of monetary policy,” according to Fed Chairman Bernanke. The unemployment rate statistic is an imperfect measure. It excludes discouraged workers and underemployment. Improvement over the last year has been exaggerated. Moreover, the unemployment rate consistent with maximum sustainable employment may change over time or may not be directly measureable. The Fed’s second goal is a judgment call, and opinions vary. Officials believe the appropriate unemployment rate target is currently between 5.2% and 6.0% – higher than it was before the financial crisis.

What happens when the Fed’s two goals conflict or when one goal is near its target and the other is far from it goal? Would a balanced response imply that a higher inflation rate is acceptable in the short run to help push the unemployment rate down? That’s possible, but it’s not what the Fed is currently forecasting.