Focus on the Fed: Interest Rates and the "Dual Mandate"
American Century Investments
July 5, 2012
Fed in Focus
When creating the Federal Reserve (the Fed), Congress set out some vitally important objectives for monetary policy—maximum employment and stable prices. We use this issue of Chart of the Week to provide some context around the Fed’s sometimes competing policy goals in its “dual mandate,” as well as simplify and summarize the inflation and jobs data informing Fed interest rate policy in a single graphic.
Inflation Moving Target
On the one hand, the Fed’s thinking on inflation would appear to be clear—they recently came right out and said that the stated long-term target for inflation is 2%. But on the other hand, the Fed left itself some wiggle room. For example, Fed Governor Charles Evans said in a late 2011 speech that “a temporary period of inflation above 2% [isn’t] something to regard with horror. . . . Rather, [2%] is a goal for the average rate of inflation over some period of time. To average 2%, inflation could be above 2% in some periods and below 2% in others.”
Employment Target Less Clear
Unlike the case with inflation, the Fed has no explicit target for unemployment. But the Fed’s most recent estimate is that the “long-run normal rate of unemployment” is somewhere between 5% and 6%. Again, Governor Evans: “The most reasonable interpretation of our maximum employment objective is an unemployment rate near its natural rate, and a fairly conservative estimate of that natural rate is 6%.” With unemployment of 8.2% at the end of May, that means the Fed is missing its employment mandate by more than two full percentage points. Meanwhile, the chart shows the Fed’s preferred measure of inflation (PCE) running at a 1.8% annual rate through April, the latest period for which data are available. Below-target inflation would appear to give the Fed plenty of room to work to improve the employment picture.
It’s worth noting that we’ve been in a roughly similar place before, following the bursting of the dot-com stock bubble in 2000 and ensuing recession of 2001. Then, the Fed cut rates dramatically, but was slow to raise interest rates because of the so-called “jobless recovery” of 2002–03, when the unemployment rate declined only slowly, and never returned to pre-recession levels. Modest inflation at that time left the door open for the Fed to keep interest rates low for an extended period, even though the recession was officially deemed to have ended in November 2001. We see this as a likely template for the current round of easing—the Fed will be slow to remove stimulus while unemployment remains stubbornly high.
Putting It All Together
Armed with this context, it is perhaps easy to understand why the Fed recently reiterated its commitment to keep rates exceptionally low through late 2014. The data also provide readers the tools to understand potential changes in Fed policy going forward—tighter monetary policy would likely require a jobless rate at or approaching 6%, or inflation in excess of 2% for an extended period. Meanwhile, easier monetary policy, such as a third round of quantitative easing, would likely require a deterioration in the employment picture or significant threat to the economy, such as economic calamity in Europe.
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The opinions expressed are those of American Century Investments and are no guarantee of the future performance of any American Century Investments portfolio. This information is not intended to serve as investment advice; it is for educational purposes only.
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