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How well is the Fed doing?
With inflation and unemployment rates fluctuating from month to month, it can be difficult to assess how well the Fed is achieving its dual objectives of maximum employment and price stability. But a little analysis can go a long way.
While many central banks have a main objective for price stability and often a secondary goal of smoothing the business cycle, the Federal Reserve Act is unusual in that it provides an explicit goal for maximum employment that, furthermore, is of equal importance to its goal for price stability.
Quantifying the Fed’s objectives for inflation and unemployment
Interestingly, these goals can be given a numerical definition even though no such definition is provided in the legislation. Since the Fed can influence inflation, the longer run forecasts indicate what inflation rate FOMC members are aiming for. That longer run rate, which is 2%, is often interpreted as the Fed’s inflation target. The unemployment rate in the longer run can be interpreted as the lowest unemployment rate – which corresponds to the maximum employment rate – that the Fed believes it can achieve and maintain. This is 4%.
The Fed’s loss function
In sum, how well the Fed is achieving its goals can be assessed by looking at the deviation of inflation from 2% and the deviation of unemployment from 4%. Since deviations can be positive or negative and it is often felt that both are equally undesirable, economists often define the loss as equal to the sum of the squared deviation of inflation from target and unemployment from its longer run level:
Loss = (inflation – 2%)2 + (unemployment rate – 4%)2
Four aspects deserve comment:
- While the loss function only involves two variables, in practice the Fed is concerned by many more measures of inflation and unemployment. Thus, the loss function and the associated analysis should be seen as a short cut to understanding Fed policy making.
- The losses are minimised when inflation and the unemployment rate are at the targeted levels.
- The costs of deviating from target rise as the deviations of inflation and unemployment grow larger. That is important for thinking about FOMC members’ views about monetary policy in the recent past.
- Too low rates of inflation and unemployment are as costly as too high rates, that is, the loss function is symmetric. While the notion of symmetric losses from inflation deviations is mainstream, the idea that central banks care as much about unemployment being below the long run level as they do about unemployment being above it is debatable.
Indeed, in recent cycles the US unemployment rate has fallen below the level that was previously thought to be consistent with full employment yet that, by itself, did not elicit a policy response. And in announcing last year the Fed’s new policy strategy which emphasises the benefits of a strong labour market, Chairman Powell said that “our revised statement says that our policy decision will be informed by our ‘assessments of the shortfalls of employment from its maximum level’ rather than by ‘deviations from its maximum level’ as in our previous statement.”
How well the Fed has achieved its objectives can be assessed using a formal loss-functional analysis. Such an investigation shows that deviations of unemployment from its long-run level, which can be thought of as the Fed’s target, have been much more important as a source of concern than deviations of inflation from the 2% target.
In turn, that observation helps explain why the Fed has not been quick to announce tapering of bond purchases at the current juncture, in which unemployment is only gradually declining towards target but inflation has surged.
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