November 22, 2010 3:12PM

Fed Can’t Serve Two Masters

Last week Congressman Pence and Senator Corker announced a bill to end the Federal Reserve’s dual mandate of price stability and maximum employment. Before getting into why this is a good start, what exactly is the dual mandate? Section 2a of the Federal Reserve Act, which sets the Fed’s monetary policy objectives, directs the Fed to:

maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long‐​term interest rates.

Building upon the notion of the Phillips curve, which suggests an historical relation between inflation and unemployment, some have read 2a as implying that the Fed should pick an inflation‐​unemployment trade‐​off that improves social welfare. It is this perceived “trade‐​off” that dominates the current actions of the Federal Reserve. Quite simply, Fed leaders, such as Bernanke, believe with a little extra inflation we can get more employment.

The problem is that this isn’t so. As soon as policymakers tried to exploit this trade‐​off, in the 1960s and 1970s, it disappeared. From about 1961 to 1966, it did indeed appear that one could choose a mix of inflation and unemployment. But from 1966 until 1980, when Volcker moved to bring down inflation, inflation and unemployment were positively correlated. It appeared that all we got was more inflation and more unemployment.

Despite the painful experiences of the 1970s, Bernanke seems intent on repeating those mistakes. Which gets to me to the point of removing the dual mandate. It forces the Fed to focus on the only thing it really has any influence over: inflation. It also removes the temptation to exploit an inflation‐​unemployment trade‐​off that never existed in the first place. 

Now given Bernanke’s views on price stability, eliminating the dual mandate can only be a first step. We ultimately need to remove the discretion of the government to indulge in the Phillips curve fantasy.