The Federal Reserve’s Open Market Committee’s (FOMC) decision last week to publicly tie monetary policy to a specific level of unemployment caught many off-guard. This historic announcement marks the first time that the Fed has publicly stated a specific unemployment rate which would trigger a change in monetary policy. This historic decision should not have come as a surprise, as it is fully consistent with the position that Chairman Ben Bernanke took when he was first nominated to succeed Alan Greenspan.
As an academic, Bernanke was a leading proponent of inflation targeting. This school of thought believes that central banks should set explicit, public targets for inflation and manage monetary policy to achieve those targets. Inflation targeting has been steadily gaining steam since it was first instituted in New Zealand in 1990. As of 2012, there are 27 central banks around the globe that embrace inflation targeting, including the European Union, United Kingdom, Korea, Brazil and Canada.
In the United States, the Federal Reserve has a dual mandate as instituted by the Humphrey-Hawkins Act, which requires it to achieve both price stability and maximum employment. The dual mandate is a compromise between those who want monetary policy to focus on full employment and those who believe that the Fed should only concern itself with keeping inflation low. These divides often trace the political fault lines with Democrats wanting the Fed to focus on providing stimulus to the economy to promote employment while Republicans prefer the Fed to interfere less frequently and focus on keeping inflation low.
There was vigorous debate during Bernanke’s confirmation as to what his goals were with respect to instituting inflation targeting at the Fed. The very first question he was asked by then-Banking Committee Chairman Richard Shelby (R-AL) began: “It is well known that you have been a proponent of inflation targeting, which is pleasing to this Senator.” Chairman Shelby went on to press the case for inflation targeting, asking the nominee, “Dr. Bernanke, do you believe an inflation targeting regime is consistent with the Federal Reserve’s other goals, that is, of long-term sustainable growth and full employment?” To which Bernanke replied, “Chairman Shelby, I subscribe entirely and wholeheartedly to the dual mandate… to the extent that naming a long-term inflation objective can help to stabilize those expectations, keep inflation under control, I think it actually significant advances our ability to meet the dual mandate and to increase employment growth.”
In fact, as Chairman of the Fed, Bernanke followed through on this promise. In January 2012, the Fed instituted a form of inflation targeting in which the Federal Reserve publicly stated a longer-term inflation objective of 2 percent. However, despite stressing the importance of reducing the unemployment rate at the very press conference in which the inflation target was announced, the Fed did not adopt any specific target for the unemployment rate. Was this a first step in weakening the dual mandate by committing the Fed to a long-term goal of low inflation despite the presence of high unemployment? Even if Chairman Bernanke was personally committed to the dual mandate, was it possible for the Fed to treat both objectives equally if it had an explicit inflation target but no corresponding target for unemployment?
This was exactly the line of thinking which then-Banking Committee Ranking Member Senator Paul S. Sarbanes (D-MD) pursued at that same nominations hearing. Senator Sarbanes highlighted this when he commended Bernanke for appreciating “the danger that if you had a numerical figure for inflation but not for unemployment, that there would be a shift in focus of policymaking and debate toward whether the Fed was achieving its inflation target and away from whether the Fed was achieving maximum employment through stabilizing output, whether you intended that to happen or not.”
Senator Sarbanes continued: “I think it is easy enough to assert that it is not your intention, that you are keeping the dual mandate in mind and so forth. But I think in the real world of the dynamics and particularly in the way the media would cover such a question, the constant focus is going to be have you hit the numbers target on your inflation goal and that it would, in effect, draw attention away from the dual mandate and the emphasis we are placing on trying to balance the two.”
Chairman Bernanke was well aware of this criticism of inflation targeting. Having discussed it in the academic setting was very different than in the actual world of policymaking, a fact he knew well from his previous time as a Fed Governor under then-Chairman Greenspan. Earlier in response to questioning from Senator Sarbanes on inflation targeting, Bernanke made the following statement: “I am entirely in favor of maximum employment. I believe that this [inflation targeting] is a method to achieve it. If I did not think it was, I would not pursue it.” Seven years later, Chairman Bernanke successfully implemented targeting. He may also have found Senator Sarbanes’ concern to be valid. To Chairman Bernanke’s credit, he addressed the point head on by tying monetary policy to both inflation and employment. Whether you agree with the dual mandate or not, it is the law of the land. We should commend the Fed Chairman for keeping his promise and following the law.