09-03-2024
Unlike most central banks, whose mandates are focused only on inflation, Congress gave the Federal Reserve a “dual mandate.” As described in the 1977 amendment to the Federal Reserve Act, this dual mandate is to “promote maximum employment and stable prices.” As I discussed earlier, the Taylor Principle is useful for calibrating monetary policy for stable prices. How should this be expanded to account for the other half of the Fed’s mandate?
There are many metrics that one could focus on in gauging the state of the labor market. The most widely used is the unemployment rate. This is measured as the fraction of individuals in the labor force who are unemployed and looking for work. The unemployment rate is measured monthly from the Current Population Survey.
Even when the economy is achieving maximum employment where economic growth is at its potential, there will still be a positive unemployment rate. This reflects the fact that individuals entering the labor force often are unemployed prior to accepting a job offer. Also, workers in the labor force may experience some unemployment when they quit in order to search for better jobs.
The level of the unemployment rate in a “neutral” labor market — that is, a labor market that does not exhibit either slack or tightness — is called the “natural rate of unemployment.” The difference between the natural rate of unemployment and the actual unemployment rate (the “unemployment gap”) is a useful metric for how the Fed is doing on the employment side of its mandate.
The inflation gap — the difference between the underlying inflation rate and the Fed’s target inflation rate — and the unemployment gap together provide measures of how the Fed is doing on its dual mandate. To incorporate the unemployment gap in calibrating monetary policy, a measure of the natural rate of unemployment is needed. I’ll discuss this is my next post.
Joseph Tracy is a Distinguished Fellow at Purdue University’s Daniels School of Business and a nonresident senior fellow at the American Enterprise Institute. Previously he was executive vice president and senior advisor to the president at the Federal Reserve Bank of Dallas. He is a regular Daniels Insights contributor, sharing his expertise on financial markets.
