The current mandate of the Federal Reserve first made its way into the Federal Reserve Act in November 1977. The 1970s were plagued with high inflation and unemployment, a severe adverse macroeconomic condition known as stagflation, which motivated Congress to reform the original Act of 1913. With the intention of clarifying the Fed’s Board of Governors and the Federal Open Market Committee’s (FOMC) roles, Congress’ Reform Act explicitly identifies “the goals of maximum employment, stable prices, and moderate long-term interest rates.” It is these goals that have come to be known as the Fed’s “dual mandate."
The first thing to notice is that the so-called dual mandate actually appears to be a triple mandate of achieving the following three goals: 1) maximum employment; 2) stable prices; and 3) moderate long-term interest rates. We shall begin by looking at the first one, maximum employment, before we turn to the other two, which can effectively be treated as a single mandate.
When thinking about the first mandate it is important to realize that there are two very important points to make: 1) maximum employment does not mean 100 percent employment or zero percent unemployment, and 2) there is not one single level of employment, carved in stone and valid for all eternity, known as the "maximum level of employment."
Economists recognize that there will always be some level of unemployment because there will always be people quitting or starting new jobs, businesses failing and new ones starting, or specific sectors contracting and others expanding. Because it takes time to find a new job, there will always be a certain level of unemployment, and thus the level that the Fed is tasked with achieving is not zero percent unemployment.
The unemployment level is one that would prevail in normal economic conditions (i.e., in the absence of a boom or recession). This rate has come to be called the “natural rate of unemployment." This natural rate is determined by structural factors that affect the flexibility or mobility of the labor market. For instance, if workers have greater mobility within their country to work in another region, this would help to reduce the natural rate of unemployment. Regulations that restrict labor mobility will tend to raise the natural rate.
It is not always obvious whether the economy is in normal economic times or even what the natural rate of unemployment is if it were. The Fed must rely on assessments from its members despite the uncertainty, and these are always subject to revision. As of September 2015, the estimates of the longer-term natural or normal rate of unemployment had a median value of 4.9 percent, ranging anywhere from 4.7 to 5.8 percent. (For more, see: The Unemployment Rate: Get Real.)
Stable Prices and Moderate Long-Term Interest Rates
In order for people and businesses to make plans for the future, they need to be reasonably confident that prices will remain relatively constant over time. As a result, price instability in the form of either deflation or rapid inflation can have drastic consequences on economic stability.
We noted above that the stable prices and moderate long-term interest rates could effectively been interpreted as comprising a single mandate. This is because long-term nominal interest rates are set with inflation expectations in mind. For any given nominal interest rate, rapidly rising prices will diminish the real interest rate that lenders receive and debtors have to pay. Thus, in an unstable monetary environment with rapidly rising prices, lenders will want to charge much higher interest rates to mitigate the inflation-rate risk. (For more, see: Understanding Interest Rates: Nominal, Real And Effective.)
Having just combined the goals of stable prices and moderate long-term interest rates into a single mandate, it may be surprising to realize that as of January 2012, the FOMC claimed that achieving its dual mandate is consistent with targeting an inflation rate of two percent. This sounds more like a single mandate, which is why one can interpret the Fed’s goals as being consistent with the European Central Bank’s (ECB) single mandate of maintaining price stability.
The Fed’s reasoning is that this inflation target, by ensuring price stability, creates a stable economic environment able to foster the goal of maximum employment. When prices are stable, people and businesses can make longer-term economic decisions necessary for stable economic growth. This in turn leads to improved employment opportunities.
The Bottom Line
Whether it is a triple, dual, or single mandate, the primary aim of the Federal Reserve is to create a stable monetary environment. To achieve this, the Fed has deemed that targeting inflation (by keeping it at a low and stable rate of two percent) is the best way to achieve such stability. So all the fuss about changing interest rates is really all about keeping prices stable in order to foster economic growth and promote maximum employment.