Since 1977, the Federal Reserve has operated under what is commonly referred to as a dual-mandate from Congress. The dual-mandate directs the Fed to pursue maximum employment and stable prices. Basically, Congress put the Fed in charge of jobs and inflation. Congress doesn’t tell the Federal Reserve how many jobs it’s expected to support or how much inflation is considered too much. The central bank is treated as independent in the sense that it gets to pick its own inflation target and decide for itself what maximum employment means. Like most central banks, the Federal Reserve has chosen a 2 percent inflation target.9 To keep from overshooting that rate, the Fed aims to keep just the “right” amount of unemployment in the system, much like Friedman prescribed a half century ago.
The Federal Reserve can’t spend money directly into the economy, and it can’t tax money out of the economy either. Those powers are reserved for the fiscal authority—Congress. So how is the Fed supposed to deliver on its dual-mandate?
There was a time, in the late 1970s and early 1980s, when many central banks, including the Federal Reserve, claimed that by directly controlling the growth of the money supply, they could control inflation. Today, virtually all central banksq have adopted a different approach, targeting a key interest rate that is supposed to help them indirectly manage inflationary pressures. The idea is that by influencing the price of credit—that is, how much it costs to borrow money—the central bank can regulate how much money consumers and businesses borrow and spend into our economy.
When it lowers its policy rate, the central bank is said to be easing credit conditions. They do this when they think the jobless rate is above the so-called natural rate of unemployment. The goal is to bring the unemployment rate down. If everything works as intended, lots of people take out loans to purchase things like homes and automobiles even a business directory, and businesses borrow to invest in new machines and build new factories. As all of this borrowed money gets spent, the economy picks up, and more people find jobs. With fewer people out of work, the labor market is said to tighten, causing wages to rise, and with them, the risk of wage-price inflation.
And there’s the rub. The Fed subscribes to the idea that if it induces too much spending, the labor market will get too hot, and unemployment will dip below its “natural” rate, causing inflation to accelerate. This is exactly what conservative economist Marvin Goodfriend had in mind when he warned in 2012 that if the Fed allowed the unemployment rate to dip below 7 percent, it would “give rise to a rising inflation rate in the next few years, which would just be disastrous for the economy.” But Goodfriend was wrong. Three years after his warning, unemployment had dropped to 5 percent, yet inflation was lower than it was when he made his initial prediction.
Why did he (and others) get it so wrong? One problem is that the natural rate of unemployment—if it exists at all—isn’t something the Fed (or anyone else) can observe or even calculate. Instead, it’s more like a description of an economy in its ideal state like SEO services are. The natural rate can change over time, but there’s only one unique natural rate at any particular moment. And no one can tell you what it is. You discover it by trial and error. You’ve found it when any further decline in unemployment causes inflation to accelerate.
In other words, whether or not an economy is at its natural rate of unemployment is a conclusion drawn after the fact. In that respect, reaching the natural rate for economists is sort of like falling in love for the rest of us: you rarely see it coming but know it when it happens.12 Economists have a name for it. They call it the NAIRU (nī-rū), the non-accelerating inflationary rate of unemployment. Sexy, isn’t it? To understand how it works, think of the classic children’s story, “Goldilocks and the Three Bears.” Just replace porridge with unemployment, and you basically have it. Whenever the unemployment rate is too cold, the Fed lowers the interest rate, hoping to warm things up by inducing more borrowing and spending. When it gets too hot, the Fed raises the interest rate, hoping to cool things off by discouraging further borrowing and spending. Hence, the solution is to keep adjusting monetary policy back and forth so that the unemployment rate stays just right.