FRBSF Economic Letter
99-04; January 29, 1999
The Goals of U.S. Monetary Policy
The Federal Reserve has seen its legislative mandate for monetary policy
change several times since its founding in 1913, when macroeconomic policy
as such was not clearly understood. The most recent revisions were in
1977 and 1978, and they require the Fed to promote both price stability
and full employment. The past changes in the mandate appear to reflect
both economic events in the U.S. and advances in understanding how the
economy functions. In the twenty years since the Fed's mandate was last
changed, there have been further important economic developments as well
as refinements in economic thought, and these raise the issue of whether
to modify the goals for U.S. monetary policy once again. Indeed, a number
of other countries--notably those that adopted the Euro as a common curency
at the start of this year--have accepted price stability as the new primary
goal for their monetary policies.
In this Letter, we spell out the evolution of the legislation
governing U.S. monetary policy goals and summarize the debate about whether
they could be improved.
The evolution of the Fed's legislative
The Federal Reserve Act of 1913 did not incorporate any macroeconomic
goals for monetary policy, but instead required the Fed to "provide an
elastic currency." This meant that the Fed should help the economy avoid
the financial panics and bank runs that plagued the 19th century by serving
as a "lender of last resort," which involved making loans directly to
depository institutions through the discount windows of the Reserve Banks.
During this early period, most of the actions of monetary policy that
affected the macro economy were determined by the U.S. government's adherence
to the gold standard.
The trauma of the Great Depression, coupled with the insights of Keynes
(1936), led to an acknowledgment of the obligation of the federal government
to prevent recessions. The Employment Act of 1946 was the first legislative
statement of these macroeconomic policy goals. Although it did not specifically
mention the Federal Reserve, it required the federal government in general
to foster "conditions under which there will be afforded useful employment
opportunities ... for those able, willing, and seeking to work, and to
promote maximum employment, production, and purchasing power."
The Great Inflation of the 1970s was the next major U.S. economic dislocation.
This problem was addressed in a 1977 amendment to the Federal Reserve
Act, which provided the first explicit recognition of price stability
as a national policy goal. The amended Act states that the Fed "shall
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." The goals of "stable prices" and "moderate
long-term interest rates" are related because nominal interest rates are
boosted by a premium over real rates equal to expected future inflation.
Thus, "stable prices" will typically produce long-term interest rates
that are "moderate."
The objective of "maximum" employment remained intact from the 1946 Employment
Act; however, the interpretation of this term may have changed during
the intervening 30 years. Immediately after World War II, when conscription
and price controls had produced a high-pressure economy with very low
unemployment in the U.S., some perhaps believed that the goal of "maximum"
employment could be taken in its mathematical sense to mean the highest
possible level of employment. However, by the second half of
the 1970s, it was well understood that some "frictional" unemployment,
which involves the search for new jobs and the transition between occupations,
is a necessary accompaniment to the proper functioning of the economy
in the long run.
This understanding went hand in hand in the latter half of the 1970s
with a general acceptance of the Natural Rate Hypothesis, which implies
that if policy were to try to keep employment above its long-run trend
permanently or, equivalently, the unemployment rate below its natural
rate, then inflation would be pushed higher and higher. Policy can temporarily
reduce the unemployment rate below its natural rate or, equivalently,
boost employment above its long-run trend. However, persistently attempting
to maintain "maximum" employment that is above its long-run level would
not be consistent with the goal of stable prices.
Thus, in order for maximum employment and stable prices to be mutually
consistent goals, maximum employment should be interpreted as meaning
maximum sustainable employment, referred to also as "full employment."
Moreover, although the Fed has little if any influence on the long-run
level of employment, it can attempt to smooth out short-run fluctuations.
Accordingly, promoting full employment can be interpreted as a countercyclical
monetary policy in which the Fed aims to smooth out the amplitude of the
This interpretation of the Fed's mandate was later confirmed in the Humphrey-Hawkins
legislation. As its official title--the Full Employment and Balanced Growth
Act of 1978--clearly implies, this legislation mandates the federal government
generally to "...promote full employment and production, increased
real income, balanced growth, a balanced Federal budget, adequate productivity
growth, proper attention to national priorities, achievement of an improved
trade balance . . . and reasonable price stability..." (italics
Besides clarifying the general goal of full employment, the Humphrey-Hawkins
Act also specified numerical definitions or targets. The Act specified
two initial goals: an unemployment rate of 4% for full employment
and a CPI inflation rate of 3% for price stability. These were only "interim"
goals to be achieved by 1983 and followed by a further reduction in inflation
to 0% by 1988; however, the disinflation policies during this period were
not to impede the achievement of the full-employment goal. Thereafter,
the timetable to achieve or maintain price stability and full employment
was to be defined by each year's Economic Report of the President.
The debate about the Fed's current mandate
The Fed then has two main legislated goals for monetary policy: promoting
full employment and promoting stable prices. With this mandate, the Fed
has helped foster the exceptional performance of the U.S. economy during
the past decade. Still, some have argued that the Fed's mandate could
be improved, especially in looking ahead to future attempts to maintain
or institutionalize recent low inflation. Much discussion has centered
on two topics: the transparency of the goals and their dual nature.
The transparency of goals refers to the extent to which the objectives
of monetary policy are clearly defined and can be easily and obviously
understood by the public. The goal of full employment will never be very
transparent because it is not directly observed but only estimated by
economists with limited precision. For example, the 1997 Economic
Report of the President (which has authority in this matter from
the Humphrey-Hawkins Act) gives a range of 5 to 6% for the unemployment
rate consistent with full employment, with a midpoint of 5.5%. Research
suggests that there is a very wide range of uncertainty around any estimate
of the natural rate, with one prominent study finding a 95% probability
that it falls in the wide range of 4 to 7-1/2 % (see Walsh 1998).
Price stability as a goal is also subject to some ambiguity. Recent economic
analysis has uncovered systematic biases, say, on the order of 1 percentage
point, in the CPI's measurement of inflation (see Motley 1997). In this
case, actual price stability would be consistent with measured inflation
of 1%. In addition, at any point in time, different price indexes register
different rates of inflation. Over the past year, for example, the CPI
has risen about 1-1/2%, while the GDP price index has risen about 1%.
Still, a transparent price stability goal could be specified as a precise
numerical growth rate (or range) for a particular index (which could take
into account any biases). However, economists have also suggested other
ways to enhance the transparency of policy. For example, publishing medium-term
inflation forecasts might help to clarify the direction of policy (Rudebusch
and Walsh 1998). Because the central bank has some control over inflation
in the medium term, its forecasts would contain an indication of where
it wanted inflation to go.
A second recent proposed modification to the Fed's goals involves focusing
to a larger extent on price stability and de-emphasizing business cycle
stabilization. Some economists have argued that having dual goals will
lead to an inflation bias despite the Fed's best attempts to control inflation.
This argument stresses that the temptation to engineer gains in output
in the short run will overcome the central bank's desire to control inflation
in the long run. As a result of elevated inflation expectations of the
public, inflation will end up being higher than the central bank intended,
despite its best efforts. This "time-inconsistency" argument, as economists
call it, coupled with the pain incurred in the 1970s as inflation skyrocketed
and in the early 1980s as inflation was reduced to moderate levels, persuaded
many that the primary goal of the central bank should be to stabilize
This view is embodied in the charter for the central bank in the new
European Monetary Union: "The primary objective of the European System
of Central Banks is to maintain price stability. Without prejudice to
the objective of price stability, the ESCB shall support the general economic
policies in the Community." Among these latter policies are "a high level
of employment" and "a balanced development of economic activities."
Economists remain divided on the importance of the time inconsistency
problem and on the need to put primary emphasis on price stability at
the expense of output stabilization. Some stress the fact that the central
bank is the only entity that can guarantee price stability, and that this
goal is not likely to be attained for long unless price stability is designated
as the primary goal. Others find the arguments for time inconsistency
implausible because policymakers, who are aware of the arguments about
an inflationary bias and see the implications for inflation, can conduct
policy without an inflationary bias (McCallum 1995). Still others argue
that the abdication of other goals is irresponsible (Fuhrer 1997). Also,
a good deal of empirical research using simulations of models of the U.S.
economy suggests that a focus on dual goals can reduce the variance of
real GDP (i.e., smooth the business cycle) while achieving an inflation
goal as well (Rudebusch and Svensson 1998).
While these issues are not yet resolved, the experience of the past two
decades provides some support to those who think dual goals that lack
transparency can function successfully. It is true that some countries
around the world have reduced inflation over this period while putting
primary emphasis on explicit inflation targeting. But at the same time,
with its current legislative mandate, the Fed also has had success in
reducing inflation, while maintaining the flexibility of responding to
business cycle conditions.
John P. Judd
Vice President and Associate
Director of Research
Glenn D. Rudebusch
Fuhrer, Jeffrey C. 1997. "Central Bank Independence and Inflation Targeting:
Monetary Policy Paradigms for the Next Millennium?" New England Economic
Review January/February, pp.20-36.
Keynes, John Maynard. 1936. The General Theory of Employment, Interest,
and Money. Harcourt, Brace, and Company: New York.
McCallum, Bennett. 1995. "Two Fallacies Concerning Central Bank Independence."
American Economic Review Papers and Proceedings, vol. 85, no. 2
(May), pp. 207-211.
Motley, Brian. 1997. "Bias in the CPI: Roughly Wrong or Precisely Wrong."
97-16 (May 23).
Rudebusch, Glenn D., and Lars E.O. Svensson. 1998. "Policy Rules for Inflation
Targeting." NBER Working Paper 6512.
Rudebusch Glenn D., and Carl E. Walsh. 1998. "U.S. Inflation Targeting:
Pro and Con." FRBSF
98-18 (May 29).
Walsh, Carl E. 1998. "The Natural Rate, NAIRU, and Monetary Policy." FRBSF
Economic Letter 98-28
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