a b s t r a c t JEL classification: E40 E43 E52 E61 Keywords: Dual mandate Federal Reserve Inflation Employment UnemploymentLabor market dynamics in the US are changing due to long-term factors including decelerating labor force growth, rising age of the labor force, and the rapid advance of e-commerce, as well as the one-time downward adjustment during 2009-2013 of the size of state and local government work forces. We discuss some of the controversies revolving around how to analyze labor markets in this dynamic environment from the perspective of monetary policymaking, given the dual mandate of the Federal Reserve to encourage both full employment and price stability. Our statistical research documents the changing association between US unemployment and core inflation. There was a perceived trade-off between inflation and unemployment in the 1950s and 1960s that gave way to stagflation in the 1970s, when both unemployment and inflation were rising. The 1980s were a transition period where the trade-off was perceived to have returned. This trade-off has not been so clear, however, when one looks at the last twenty years. Since 1995, a period of stable and low inflation was consistently observed despite considerable cycles in the unemployment rate. Our theoretical discussion provides a dynamic interpretation of the shifting nature of labor markets, with the objective of pointing the way for future research while highlighting crucial differences in possible interpretations that could fuel debate, both inside and outside the Fed, over how the Fed should manage its dual mandate. The dynamic changes being seen in US labor markets all suggest that the effectiveness of monetary policy to encourage full employment may be vastly overstated. If this interpretation is correct, the Fed may need to reconsider how to manage its dual mandate and react less aggressively to perceived labor slack that may be due to longer-term structural shifts over which the Fed has no influence.
a b s t r a c t JEL classification: E40 E43 E52 E61 Keywords: Dual mandate Federal Reserve Bayesian inference Inflation EmploymentWhen the Federal Reserve was established by the US Congress in 1913, its charter mandated that the new central bank "promote an elastic currency" and the institution was given extraordinary powers to serve as a lender of last resort to the banking system. Congress was reacting to the cycle of financial panics that had beset the country since the Civil War and had worsened with the Panic of 1907. Congress sought to find a remedy to prevent runs on banks turning into full-fledged financial crises. The term "elastic" in the opening words of the charter was intended to underscore the need for a robust banking system that could withstand shocks and not collapse upon itself. There was no mention whatsoever of a dual mandate of promoting price stability and encouraging full employment. With prodding from the US Congress, the Federal Reserve became highly involved in the management of the economy of the United States after WWII, focusing on inflation and full employment objectives. In 1993 Professor John Taylor set forth an elegant and simple framework (aka, the Taylor Rule) for analyzing the interest rate policy of the Federal Reserve in terms of its dual mandate. This paper examines Federal Reserve behavior from the mid-1950s to 2011 through the lens of the Taylor Rule. Our contribution is to use a dynamic linear model with Bayesian inference to update the evolution through time of the key parameters surrounding the inflation and full employment mandates, using only the information available to the Federal Reserve at each point in time. Our findings provide a more nuanced quantitative view than is previously available in the literature of how the Federal Reserve shifted its management of its dual mandate over time and in response to different economic challenges. Moreover, our research leads to serious questions of how Federal Reserve decision making may change in the future, following the financial panic of 2008, pointing toward numerous avenues for new research.
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