Designing a simple loss mandate for the Fed: Does the dual mandate make sense?

Variable and high rates of price inflation in the 1970s and 1980s led many countries to delegate the conduct of monetary policy to instrument-independent central banks. Drawing on learned experiences, many societies gave their central banks a clear mandate to pursue price stability and instrument independence to achieve it. The academic literature often distinguishes between goal- and instrument-independent central banks. Goal independence, that is, the freedom of the central bank to set its own goals, is difficult to justify in a democratic society. However, instrument independence, that is, the ability of the central bank to determine the appropriate settings of monetary policy to achieve a given mandate without political interference, is arguably less contentious if the central bank can be held accountable for its actions. Advances in academic research, notably the seminal work of Rogoff (1985) and Persson and Tabellini (1993), supported a strong focus on price stability as a means to enhance the independence and credibility of monetary policymakers. As discussed in further detail in Svensson (2010), an overwhelming majority of these central banks also adopted an explicit inflation target to further strengthen credibility and facilitate accountability. One exception to common central banking practice is the U.S. Federal Reserve, which since 1977 has been assigned the so-called dual mandate, which requires it to promote maximum employment in a context of price stability. Only as recently as January 2012, the Fed finally announced an explicit long-run inflation target, but also made clear its intention to keep a balanced approach between mitigating deviations of both inflation and employment from their targets.

Does the Dual Mandate Make Sense? Yes, it makes a lot of sense. Using the Smets and Wouters (2007) model of the U.S. economy, we find that the role of the output gap should be equal to or even more important than that of inflation when designing a simple loss function to represent household welfare. Moreover, we document that a loss function with nominal wage inflation and the hours gap provides an even better approximation of the true welfare function than a standard objective function based on inflation and the output gap. Our results hold up when we introduce interest rate smoothing in the simple mandate to capture the observed gradualism in policy behavior and to ensure that the probability of the federal funds rate hitting the zero lower bound is negligible.