This post is part of a symposium on inflation. Read the rest of the symposium here.
Over the past several months, there has been a vigorous debate about whether and how the government should respond to a recent uptick in inflation. On one side, a group of prominent government officials, academics, and commentators argue that the Federal Reserve should rapidly raise overnight interest rates to reduce annual inflation to two percent. Others maintain that current price appreciation is “transitory,” a product of the pandemic, and likely to dissipate without any response from central bankers. On their view, hiking rates will backfire, dragging the economy down with little long-term benefit.
What both sides of this debate assume is that fighting inflation is part of the Fed’s job: that the Fed has a “dual mandate”—maximum employment and price stability—and that in situations like these, with prices spiking for a range of goods and services, the Fed is supposed to take steps to tighten financial conditions with a view toward constraining the demand for goods and services. But this assumption reflects a widespread misunderstanding. Congress did not design the Fed to minimize price increases as a general matter. Instead, it gave the Fed a single mission—promoting monetary expansion at a rate consistent with full capacity utilization in the economy over the long run. In fact, Congress was concerned primarily with deflation, a monetary problem that can trigger deep recessions; legislators hoped that the Fed could address this problem by stimulating bank lending and preventing economic contractions.
In this post, I examine the Fed’s statutory mandate. My hope is that doing so will illustrate why we should not rely on the Fed alone to tackle elevated prices and help motivate efforts to expand the macroeconomic policy toolkit.
The Fed’s Function: Administering the Banking System
To understand the Fed’s mandate, it is necessary first to recognize that the Fed—by design—does not supply most of the money in the United States. Government-chartered, investor-owned banks do. These banks issue a type of money called “deposits,” which are used by employers to pay salaries (e.g., “direct deposits”) and households to pay credit card bills. Cash—the coins issued by the U.S. Mint and paper notes issued by the Fed—plays a comparatively minor role in the economy. Cash is something that banks promise to give their customers when they ask for it, but that their customers rarely ask for and seldom use.
As I argue in forthcoming work, the Fed’s job is to oversee the banking system and ensure that it creates enough deposits to keep the nation’s resources productively employed. To do this, the Fed serves as a bank for banks: it adjusts the balances that banks hold in accounts with the Fed, it changes the interest that it pays on these accounts, it lends to banks directly, and it tightens and loosens restrictions on the size and composition of bank balance sheets.
Prior to the Fed’s founding, the growth of the money supply was largely a function of lending decisions by investor-owned banks chartered by the states and the federal government. The legislators who delegated monetary expansion to private investors, in particular those who passed the National Bank Act during the Civil War, were very much concerned with limiting inflation. They worried that if the government issued the money supply directly (or delegated money issuance to government-run banks), officials would be unable to resist expanding the money supply to pay for current consumption and avoid levying taxes, thereby depreciating the currency and damaging the economy. But the decision to outsource money creation was extremely controversial, fueling decades of political opposition. It also proved economically problematic. Policymakers eventually discovered that if investor-owned banks were permitted to decide for themselves how much to expand their balance sheets they would sometimes stumble into periods of deflation, often as a result of runs and panics. In 1913, Progressive Democrats established the Fed to address this problem by administering the banking system to prevent monetary contraction and economic recessions. Congress built the Fed to fight deflation.
Following a massive deflation between 1931 and 1933, Congress amended the Federal Reserve Act to strengthen the power of its government-run Board. Shortly thereafter, in 1937, this Board prepared a statement on “The Objectives of Monetary Policy.” Its statement explicitly recognized that economic stability—understood as the “full employment of labor and of the productive capacity of the country as can be continuously sustained”—would only sometimes entail price stability. According to the Board, there were “situations when the restoration and maintenance of relatively full employment may be possible only with an advance in prices.” Inflation, in other words, was an acceptable cost, indeed a desirable one, if it resulted in greater sustainable employment. It was only when price increases led to economic instability and subsequent contractions, reducing employment and leaving economic resources on the sidelines, that Fed officials thought the Fed should intervene.
After World War II, Congress passed the Employment Act of 1946, directing all agencies, including the Fed’s Board, “to use all practicable means consistent with its need and obligations and other considerations of national policy . . . to promote maximum employment, production, and purchasing power.” The Employment Act represented a remarkable commitment on the part of the government to foster broad-based economic growth. It also reflected the sort of thinking that motivated the Board’s 1937 statement: that the government should try to keep the economy growing and that changes in prices were relevant not for their own sake but only insofar as they affected that goal.
In 1977, Congress added Section 2A to the Federal Reserve Act, charging the Fed with “maintain[ing the] long run growth of the monetary and credit aggregates commensurate with the economy’s long-run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Note that, in this instruction, maximum employment and stable prices—the two functions that commentators tend to highlight today—are included as among the macroeconomic consequences of full capacity utilization, rather than as competing desiderata that the Fed is supposed to trade off. The animating idea is that when the economy is growing at its fullest potential, everyone who is able to produce goods and services will have a job, prices will be stable, and the cost of borrowing money for further investment will be moderate. Bringing about these macroeconomic conditions is not a direct goal for the Fed; rather, the Fed’s mission is to administer the banking system in a way that grows the money supply at a rate that is consistent with achieving them over the long term.
The legislators and Fed officials at the time understood Section 2A to be merely reiterating the Employment Act and incorporating it expressly into the Fed’s own organic statute. As the Fed’s Chairman, Arthur Burns, put it, the text, initially included in a 1975 resolution, “adds nothing new to the objectives of Federal Reserve policy as already defined by statute [in the Employment Act]”). The Fed’s job, as policymakers then recognized, was not to combat inflation—it was to ensure that banks create enough money and credit to keep the nation’s productive resources fully utilized, which meant pursuing maximum employment. Congress, in other words, designed the Fed to keep the economy growing, not slow it down for the sake of stable prices in the short-to-medium term.
This distinction is important because there are many reasons that, in the short-to-medium term, the economy might not achieve full potential—as manifested by maximum employment, price stability, and moderate long-term interest rates. And often these reasons have nothing to do with monetary expansion, the only variable Congress expected the Fed to control. For example, supply shortages of key goods and services can cause prices to rise for months or even years while producers adapt to satisfy changing market demand. The Fed’s job is not to stop these price rises—even if policymakers might think stopping them is desirable—just as the Fed’s job is not to engineer long-term interest rates so that they are “moderate” or to lend lots of money to companies so that they can hire more workers. The Fed’s job is to ensure that a lack of money and credit created by the banking system—an inelastic money supply—does not prevent the economy from achieving these goals. That is its sole mandate.
Moving Beyond the Fed
What does this understanding of the Federal Reserve Act tell us about today’s debates? To begin, it tells us that the Fed should tighten its policy stance only when the rate of expansion of money and credit is inconsistent with full capacity utilization in the long run. Raising interest rates to sap aggregate demand merely to prevent price indices from rising above a certain annual target is at odds with the Fed’s mandate. Rather than increase production, hikes geared primarily toward suppressing short term price increases will stunt long-run growth by disincentivizing businesses from making the sorts of investments required to expand their capacity to meet growing demand. Such a policy, similar to what many central banks have pursued in recent decades, can instead be expected to result in ongoing underinvestment and a persistent failure to achieve full capacity utilization. (In this regard, the Fed’s recent shift toward treating price stability as a level path rather than a rate of change is step in the right direction.)
More broadly, returning to the statutory framework helps clarify that, despite what we have witnessed over the past several decades, the Fed is not designed to serve as an all-purpose manager of macroeconomic cycles. This idea, which has its roots in the 1980s and the “Volcker shock,” is the product of a global consensus among economists and central bankers about the proper role of central bankers (one that is consistent with the statutory mandates of many other central banks, for example, the ECB). But not only was this sort of central banking not what Congress had in mind, many ups and downs in the economy have little to do with the money supply and could be much more effectively and equitably managed using other means. Indeed, in 1978, Congress expressly rejected overreliance on monetary policy to deal with price appreciation, stating that it could “exacerbate both inflation and unemployment.” Instead, “the coordinated use of fiscal and monetary policies in conjunction with specific targeted policies are necessary to combat inflation.”
It is time for policymakers and especially legislators to develop new tools to address both inflation and recessions. On the fiscal side, Congress might consider adopting new automatic stabilizers, like preauthorized stimulus payments for households triggered by sustained increases in the unemployment rate or debt modification programs. To mitigate undesirable price surges, officials could pursue reforms to government healthcare programs and invest more in healthcare provisioning. The government might manage climbing housing pricing through new zoning polices and federal investment in low-income housing. Industrial and trade policy could target bottlenecks and direct resources toward expanding capacity in key sectors like semiconductors, food, and energy. Antitrust enforcement can check price increases in highly concentrated sectors. When inflation is the result of supply side constraints as opposed to excess monetary expansion by the financial system, these measures are likely to be more effective and equitable—and consistent with the Fed’s mandate—than aggressive monetary tightening, which dampens activity across the economy. Fortunately, we have an administration that appears to understand this and a range of experts working to develop a better framework for macroeconomic governance.