Early in the pandemic, Federal Reserve Chairman Jerome Powell emphasized that the Fed intended to pursue the goals of maximizing employment and allowing inflation to rise above its 2 percent target to make up for past shortfalls below that target. The experience of the past few years should cause us to question this dual mandate.
Beginning in March 2020, expansionary monetary policy combined with government stimulus spending put lots of money in Americans’ pockets. This contributed to a boom in household consumption spending, shortages and rising prices of durable goods — in other words, to the inflation we see today.
On the employment side, spending expanded so rapidly that, while service businesses such as restaurants and airlines reduced their operations, many goods-producing businesses had a hard time recruiting or retaining enough workers to keep up with demand. These supply-side problems were exacerbated by generous unemployment compensation that enabled laid-off workers to be more selective about jobs or take extended sabbaticals.
The tension dates back to at least 1977, when Congress amended the Federal Reserve Act to state that the Fed should promote “maximum employment, stable prices and moderate long-term interest rates.” But Federal Reserve monetary policy only indirectly effects employment, while it controls inflation and aggregate spending more directly. Inflation would be much less of a problem if the Federal focused on what it can do best.
With stable prices, spikes in unemployment would be less common, too. In the long run, price stability and full employment do not conflict.
And although inflationary monetary policy can contribute to declining unemployment, the relationship is at best temporary. To the extent monetary policy can be used to fund generous unemployment compensation, as it was during the pandemic, it can even contribute to fewer people working. When the resulting inflation is high over an extended period, it tends to be more unstable, which contributes to higher average unemployment.
During a recession when unemployment is high, the Fed can still keep inflation in check without preventing economic recovery, though it may take longer. High unemployment is caused by decisions households and businesses make to reduce spending. The economy has a self-correcting mechanism, by which reductions in spending and increased savings lead to lower prices and interest rates. This eventually creates incentives for people and businesses to buy more goods and services and to fund those additional purchases by borrowing more. This process leads to a gradual expansion in employment as businesses hire more people to produce more consumer and investment goods.
This can work the other way, too. While expansionary monetary policy may hasten the recovery from a recession, eventually the resulting higher prices have the opposite effect, discouraging purchases and leading to an offsetting decline in jobs. We are already beginning to see a reduction in the quantity of goods and services demanded caused by rising prices and the Fed’s more restrictive monetary policy to bring down inflation.
Chairman Powell claims that the Fed will do whatever it takes to reduce inflation, but we will see how serious he is. If, as is likely to be the case, unemployment starts rising, the stock market continues to decline and rising interest rates drive up the cost of borrowing, the Fed will be subject to political pressure to return to expansionary monetary policy to stimulate the economy.
If the Fed responds to this pressure by easing monetary policy before inflation is under control, we may experience a “go-stop” period similar to the period that ended with a severe recession in the early 1980s.
Beginning in the mid-1960s, as the economy was booming, the Fed raised interest rates “only hesitantly” to keep unemployment low. When inflation became a problem, the Fed pursued more restrictive monetary policy. Then unemployment rose and the Fed started expanding the money supply again to stimulate spending. But during each subsequent cycle, inflation rose to a higher level than the last one and unemployment fell only temporarily before rising again.
This process only ended when the Fed, under the leadership of Paul Volcker, raised the federal funds rate sharply in 1979. During Volcker’s tenure and also that of Alan Greenspan after him, the Fed demonstrated a commitment to preemptively raising interest rates before inflation became a problem.
The more the Federal Reserve can be constrained by rules, particularly if those rules strongly prioritize limiting inflation or aggregate spending, the more likely it will do what it takes to ensure price stability. If full employment was not a part of its mandate or clearly considered to be a secondary goal, the Fed would have a harder time justifying allowing the money supply to expand as much as it did in recent years. The result would be more stable prices and employment in the long run.
Tracy C. Miller is a senior policy research editor with the Mercatus Center at George Mason University.