Go to the Globe and Mail homepage

Jump to main navigationJump to main content

Report on Business

Economy Lab

Delving into the forces that shape our living standards
Best Business Blog, EPPY awards, 2011 and 2012

Entry archive:

Economy Lab has moved

Only Globe Unlimited members will now have access to a wide range of insightful commentary
and analysis on the economy and markets previously offered on this page.


Globe Unlimited subscribers will be able to read these columns,
written by some of Canada’s most deeply respected economists,
such as Christopher Ragan, Sheryl King, Andrew Jackson, and Clement Gignac,
as part of our ROB INSIGHT section.


All of our readers will still be able to browse the Economy Lab archives and read our
broader coverage of economic data and news by accessing their 10 free articles a month.


Learn more about Globe Unlimited and how to subscribe.

The Federal Reserve Building in Washington. (STELIOS VARIAS/Reuters)
The Federal Reserve Building in Washington. (STELIOS VARIAS/Reuters)

MIKE MOFFATT

Why the Fed should abandon its dual mandate Add to ...

With U.S. inflation expectations remaining low, the Federal Reserve and Ben Bernanke have faced a great deal of criticism for failing to meet their mandate. While the Fed should be engaging in looser monetary policy, part of the problem is that the Fed’s own choice of mandate was a poor one.

The Federal Reserve’s dual mandate can be summarized as keeping inflation (as measured by CPI) at the rate of 2 per cent, while keeping unemployment at the natural or “normal” rate of between 5.2 to 6 per cent. This mandate is problematic for at least two reasons.

More Related to this Story

Unlike the Fed, the Bank of Canada has a simple, single-mandate to keep inflation between 1 and 3 per cent. It can consider other factors, such as unemployment and allow inflation expectations to deviate slightly from 2 per cent. But expectations should not leave the 1 to 3 per cent zone.

Trying to target two variables at once is difficult since it is not clear what the trade-off should be between the two targets. Suppose the unemployment rate was at 10 per cent. Would a high inflation rate of, say, 7 per cent be appropriate in order to bring down unemployment? If not, then, how high? There is no obvious way to trade off the two objectives.

The second problem with the Fed’s dual mandate is the inclusion of an unemployment rate target. In order to properly target unemployment, we need to know how low we can sustainably push the unemployment rate. Once the maximum rate of employment is reached, any additional loosening of monetary policy brings only additional inflation, not additional employment. This concept is known as the NAIRU (Non-Accelerating Inflation Rate of Unemployment), a concept popularized and partly developed by Milton Friedman. Unfortunately the NAIRU is not straight forward to estimate, which the Fed itself admits when it states:

“The maximum level of employment is largely determined by non-monetary factors that affect the structure and dynamics of the labour market. These factors may change over time and may not be directly measurable. 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 maximum level of employment”

A 1997 Journal of Economic Perspectives research study found that estimates of the NAIRU are by their nature imprecise, and can vary by two percentage points. A target which is hard to estimate and changes over time is far from ideal.

The Federal Reserve needs to consider changing its mandate to something more straight forward, such as the Bank of Canada’s inflation targeting or targeting the growth rate of Nominal Gross Domestic Product (NGDP). A clearer mandate is not a panacea, but it would give the Fed additional guidance on what actions it should take at any point in time.

Follow on Twitter: @mikepmoffatt

In the know

Most popular video »

Highlights

More from The Globe and Mail

Most Popular Stories