The current mandate of the U.S. Federal Reserve was shaped by events of the 1970s, which was marked by simultaneous high inflation and unemployment, a condition known as stagflation. The Federal Reserve Act of 1977 modified the original act establishing the Federal Reserve in 1913 and clarified the roles of the Board of Governors and Federal Open Market Committee (FOMC).

Congress explicitly stated the Fed's goals should be "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 about the dual mandate is that it is actually three goals: 1) maximum employment; 2) stable prices and 3) moderate long-term interest rates. We shall begin by looking at maximum employment before turning to the other two goals, which can effectively be treated as a single mandate.

Key Takeaways

  • The Federal Reserve has two mandates: maintaining maximum employment and maintaining stable prices and moderate long-term interest rates.
  • Maximum employment doesn't mean 100% employment, which is not possible, but rather the level of employment that is likely in normal economic conditions when there is neither a boom or a recession.
  • Stable prices and moderate long-term interest rates can be seen as essentially one mandate, since long-term interest rates are set with an eye to managing pricing pressure and inflation.

Maximum Employment

When thinking about the first mandate 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 there will always be some level of unemployment. This is 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 the Fed is tasked with achieving is not zero percent unemployment.

The desired 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 known as the natural rate of unemployment. This natural rate is determined by structural factors that affect the flexibility or mobility of the labor market. For example, 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 May 2020, the estimate of the longer-term natural or normal rate of unemployment ranged anywhere is about 4.5 percent. (For more, see: The Unemployment Rate: Get Real.)

0.25%

The Fed Funds rate as of March 2020. The FOMC cut rates by a full percentage point in response to the coronavirus pandemic.

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 stable prices and moderate long-term interest rates could effectively be 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 must 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.)

On August 27, 2020 the Federal Reserve announced that it will no longer raise interest rates due to unemployment falling below a certain level if inflation remains low. It also changed its inflation target to an average, meaning that it will allow inflation to rise somewhat above its 2% target to make up for periods when it was below 2%.

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 since January 2012, the FOMC has targeted an inflation rate of two percent to achieve its dual mandate. This sounds more like a single mandate, which is why one can view the Fed as being consistent with the single mandate of price stability sought by the European Central Bank (ECB).

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 leads to improved employment opportunities.

Stable prices and long-term interest rates are Federal Reserve goals that directly influence each other, making them essentially one mandate.

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.