For the sake of economic stability, we must put the imaginary inflation-unemployment tradeoff behind us.
There is no inflation-unemployment tradeoff.
U nemployment last month reached an historic low, but inflation remains at a 40-year high. The Federal Reserve’s mandate requires it to pursue both full employment and price stability. Fed officials are now scrambling to get a handle on inflation. However, commentators are worried monetary tightening will hamper the ongoing labor-market boom.
These concerns are misplaced. There’s no tradeoff between inflation and unemployment. In fact, provided the Fed is competently managing total spending (the sum of spending by consumers, businesses, and all levels of government), valued in current dollars, price stability and full employment go hand-in-hand. This isn’t a fringe belief. It’s the hard-earned macroeconomic wisdom of the last four decades, inexplicably abandoned when we need it the most.
The dual mandate comes from a 1977 statute. Ironically, this was right when the economics profession was putting the myth of an inflation-unemployment tradeoff to rest. A major feature of old-school Keynesianism, which dominated academic economics from the end of World War II until the 1970s, was the Phillips curve. This relationship purported to offer policymakers a menu of options for achieving their desired combination of inflation and unemployment. The belief was that policymakers could permanently reduce unemployment by creating inflationary wage increases, which would fool workers into accepting jobs that they would otherwise reject in exchange for higher-than-expected wage offers – a phenomenon that economists call “money illusion.” A major problem with this belief was its assumption that people would never discover the trick.
Milton Friedman took this view to task in his 1968 presidential address to the American Economic Association. He argued that people’s decisions to work depended upon the purchasing power of their earnings. While higher money wages may fool people into working temporarily, this effect would fade once they realized their wages lacked the purchasing power they expected. “Money illusion” is a short-run phenomenon.
Friedman’s theory implied that the economy has a natural rate of unemployment towards which it trends. There will always be some unemployment, due to job turnover, business starts and failures, and other normal occurrences. But as wages and prices adjust, markets would put to work as many people as possible. Once workers came to expect inflation-induced wage hikes, unemployment would return to its natural rate. Trying to fool people into working through unexpected inflation is futile in the long run.
What does this history lesson have to do with the Fed’s dual mandate? If the Fed keeps total spending growing at a constant rate, then there’s no need to worry about full employment separately from price stability. In fact, pursuing price stability will ensure that the unemployment rate remains fairly close to its natural rate in many cases — an idea dubbed the “divine coincidence” by economists Olivier Blanchard and Jordi Galí.
The seeds planted by Friedman germinated into the workhorse model of business-cycle studies: aggregate demand and aggregate supply. The former depends on fiscal and monetary policy. The latter depends on productivity. By boosting demand, the Fed can temporarily stimulate the economy. Unemployment will fall in the short run. But in the long run, as inflation rises, labor markets will cool off. All we get is a permanently depreciated dollar. The supply side ultimately determines how much we can produce and how much labor we can usefully employ.
Monetary policy affects total spending, and hence aggregate demand. To fight recessions, it’s appropriate for the Fed to push back when demand collapses, stabilizing both labor markets and the dollar’s value. You can’t have one without the other. How much employment is full employment depends on supply, over which the Fed has no power. All the central bank can do is pick the level of demand, and hence the purchasing power of money.
This doesn’t mean the Fed is unimportant. On the contrary: Stable demand is a boon for the economy. Instead, it means the employment component of the mandate is superfluous at best and dangerous at worst. By keeping nominal income on a steady path, the Fed creates a solid foundation for labor markets to flourish. No micromanaging needed. However, the full-employment plank has been used by some to pressure the Fed to continue its monetary expansion on the grounds that minority unemployment rates are still too high. This is a worrying shift in standards. Racial and economic justice are important, but the Fed’s mandate doesn’t include them. Minority unemployment rates are usually higher than the overall unemployment rate, indicating a structural cause, not a cyclical one. Problems like these are beyond the Fed’s reach.
Economists should be leading the charge on reforming the Fed’s mandate so that we can avoid situations like the one in which we currently find ourselves. Sadly, many have gotten lost in the woods because they ignored the map provided by the aggregate supply-aggregate demand model. Some made a fetish out of theory, creating ever-more mathematically sophisticated yet practically irrelevant models. Others abandoned theory for pure statistical analysis. Both approaches are a dead end. Economists have a once-in-a-generation opportunity to advise public officials on the best way to reorient the Fed. If they return to their roots and put their training to work, the economics profession and the public will be much better off.
What can Congress do about the Fed? One simple option is removing the full-employment plank from the mandate. A bill recently filed by Representatives French Hill (R., Ark.) and Byron Donalds (R., Fla.) would do just that, committing the Fed to price stability alone. This seems appealing at a time of high inflation. But we should be cautious. Unexpected changes to aggregate supply could make a solely price-focused Fed double down on economic damage. For example, a negative supply shock would make it harder to produce goods and services, resulting in economy-wide price hikes. The Fed could bring prices back down, but only by contracting demand. We’d get the desired inflation rate, but fewer goods and services. Low and predictable inflation is less attractive if getting it makes us all poorer.
An alternative would stabilize not prices, but aggregate demand itself. By keeping nominal income steady, the Fed could fight demand-side problems while not making things worse when there are supply-side problems. However, the American public might have a harder time understanding a nominal-income target than an inflation target. Stabilizing the dollar makes intuitive sense. Stabilizing current dollar-valued income is trickier. Any monetary reform must balance economic wellbeing with public buy-in. While nominal-income targeting is the better rule, inflation targeting is easier to sell. Navigating this tension requires both careful economic reasoning and prudent statecraft.
The public is understandably angry about the return of high inflation. Members of Congress are right to revisit the Fed’s mandate. Focusing solely on price stability is a promising option. However, it could have consequences that undermine the sustainability of monetary reforms. Instead, Congress should consider giving the Fed a nominal income-focused mandate. Doing so would avoid the unnecessary confusion surrounding inflation and unemployment. For the sake of economic stability, we must put the imaginary inflation-unemployment tradeoff behind us.
Bryan P. Cutsinger is an assistant professor of economics in the Norris-Vincent College of Business and a research assistant professor at the Free Market Institute at Texas Tech University. Alexander William Salter is an associate professor in the business school at Texas Tech University, a research fellow at TTU’s Free Market Institute, and a senior fellow at AIER.