The Federal Reserve’s Dilemma
The US Central Bank was created by the Federal Reserve Act of 1913 and, at that time, its main objective was to ensure stability in the US financial system following the banking panic of 1907. As the banking system evolved over the decades, in 1977 Congress amended the original Act to establish economic goals for the Fed – the maximum level of employment consistent with stable prices. In practice there were no specific targets set by Congress, so the Federal Reserve established an objective to keep inflation at around 2% while working to maintain full employment, the so-called “dual mandate”.
While many believe that monetary policy is well suited to maintaining “low and stable inflation” through setting short-term interest rate levels and controlling the supply of money, there are many factors that influence employment in the US economy, including population growth, labor regulations, global competition and educational achievement. Moreover, at times external developments such as global conflicts and the pandemic are also beyond the influence of the Fed.
Given its powers, the main lever the Fed uses is the setting of short-term interest rates – specifically the Fed Funds rate, the rate at which banks can borrow from each other for very short-term time periods. By adjusting this overnight rate the Fed can influence other rates, particularly the interest rates on short-term borrowing by the Treasury and interest paid by banks to savers. This distinction is important as other interest rates, particularly on longer-term Treasury securities and mortgage and corporate borrowing, are set by supply and demand in the market over which the Fed has much less influence.
At most times economic condition will indicate how the Fed should act to adjust interest rates. During recessions the unemployment rate rises while inflation generally falls, pointing clearly to the lowering of the Fed Funds rate to help stimulate the economy. Conversely, when economic growth has been strong and wages and prices are rising, higher interest rates are designed to slow growth and bring inflation lower, even at the expense of slightly weaker labor markets.
But what about when the Fed’s goals are in conflict? While inflation is low compared to the recent pandemic period, the Fed’s preferred measure of inflation – the 12-month change in prices paid for personal consumption items, excluding the volatile food and energy categories, has increased from a recent low of 2.6% in April to 2.9% in August, with concerns that as tariff costs are filtered through the economy this key inflation measure will rise farther above the Fed’s 2% inflation objective. At the same time, there are signs that the labor market is softening, with gains in jobs recently grinding to a halt and the unemployment rate inching higher to 4.3% in August from a 50-year low of 3.4% in April 2023.
For perspective, since January 2001 the unemployment rate has averaged 5.7% while the target Core PCE (Personal Consumption Expenditures) inflation measure has averaged 2.1%. In this context, the unemployment rate is below its average for the last 25 years while the inflation rate is slightly above its quarter-century average. While that combination might suggest the Fed should raise interest rates, the recent weakening of labor market conditions has caught the attention of both the Fed and the Administration. That development led to the 1/4-point reduction in the Fed’s policy rate at its September 17 meeting, with many expecting additional 1/4-point reductions at the meetings on October 29 and December 10. But some on the Federal Reserve’s policy committee – the Federal Open Market Committee (FOMC) – are warning that additional rate cuts risk allowing inflation to rise farther above the 2% objective at a time when the level of prices is already squeezing consumers. This is the dilemma facing Federal Reserve decision makers, and the recent government shutdown has halted the release of important up-to-date measures of the labor market, with key inflation readings due in the second half of October. This is the background in which Fed Chair Powell recently noted “there is no easy answer” to the next policy moves by the Fed as the FOMC faces a challenging dilemma.
