The Fed's maximum sustainable employment mandate

The Federal Reserves has a dual mandate, assigned to it by Congress, that calls for it to promote maximum employment and price stability. One objective of such mandates is to provide performance measures that can be used to judge whether the Fed is doing a good job. To be used for such a purpose, however, it must be possible to measure what maximum employment and price stability mean.

In the case of price stability, few think it should be interpreted literally – that some accepted index of prices should remain constant over time. Instead, price stability is normally taken to mean a low and stable rate of inflation. In 2012, the policymaking committee of the Federal Reserve, the Federal Open Market Committee, or FOMC, defined 2% inflation as the rate consistent with its mandate.

The FOMC has not been as clear in operationalizing the objective of maximum employment. In fact, they have moved to make it increasingly opaque. The FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy was revised in August 2021 to define the employment goal as “a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors. . . Consequently, it would not be appropriate to specify a fixed goal for employment; rather the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level, recognizing that such assessments are necessarily uncertain and subject to revision.”

In short, the FOMC has said it doesn’t know how to measure one of its key objectives. One does have to sympathize with the FOMC – labor markets are complex, employment depends on business cycle factors but also on factors that influence labor force participation decisions, structural shifts arising from changing patterns of work (home or in the office), technological innovations that shift the types of skills demanded in the workplace, and many other factors. However, by being unable to offer guidance on this key policy objective, in contrast to the 2% inflation target, the public faces a more difficult problem in predicting Fed policy. For example, while inflation is currently well above its 2% target does the FOMC see current employment as too high or too low?

The figure shows the unemployment gap in blue (unemployment minus 4% -- 4% because that is the median projection among FOMC participants of longer-run unemployment) and the inflation gap (measured by the personal consumption price index less food and energy minus 2%). Throughout 2021, inflation exceeded the Fed's target, suggesting the need for tighter monetary policy, but at the same time, unemployment was above 4%, suggesting the Fed should not tighten. But while the unemployment gap was clearly falling, it was the dramatic rise in inflation in excess of 2% that was the chief development. By December 2012, the unemployment gap had entered negative territory, while the climb in the inflation gap, after looking like it might be pausing over the summer of 2021, jumped significantly in the Fall. Only in March 2022 did the FOMC decide to raise its policy rate.    

Since Spring 2022, the unemployment rate gap has remained roughly constant with the unemployment rate around 3.6%. Inflation peaked in February at 5.4%, ending the year at 4.4%. 

These gaps shows the economy at a moment of time. Just looking at the figure suggests the Fed still needs to focus on bringing inflation down. That will lead to some increase in unemployment, but the FOMC projections already suggest unemployment is below the level viewed sustainable. Current gaps reflect the consequences of the Fed's past policies, including its delay in responding to the surge in inflation seen in the figure. Because policy affects the economy with a lag, the Fed must be forward looking; policy decisions will depend on the FOMC's forecasts of the future path of unemployment and inflation. 

Last year, inflation was central problem the Fed had to address. In December 2022, the FOMC projections indicated members expected 2023 would end with 4.6% unemployment and core inflation at 3.5%. If these projections pan out, the economy will end this year both unemployment and inflation still too high. Fed actions will reflect the FOMC's assessment of the trade-offs between these two goals. Thus, understanding the Fed's actions will require more clarity on how it will balance the competing goals of ensuring both gaps return to zero. 

Of course, this discussion was all based on the assumption that 4% unemployment is what the Fed considers to be the rate associated with their mandate of maximum sustainable employment. Understanding the Fed's decisions in balancing the two components of its dual mandate would be aided it it could be as clear about its interpretation of maximum sustainable employment as it is about its interpretation of price stability.