No Triple Mandate for the Federal Reserve

A recent speech by Federal Reserve Chair Janet Yellen got considerable attention over her subtly implied suggestion that the Fed consider taking on a third mandate—reducing economic inequality—in addition to its current dual mandate of keeping inflation in check and unemployment as low as possible. Less noticed, but just as important, were her comments that “business ownership is associated with higher levels of economic mobility,” and that “it has become harder to start and build businesses.”

So is there a role the Fed could play in making entrepreneurship easier and less risky? Yes. Be more modest. Replace the Fed’s current dual mandate with a single mandate—keep the price system as honest and stable as possible.

The dual mandate creates a contradictory tension that makes it practically impossible for the Fed to function effectively. It is fairly easy for the Fed to keep inflation low: Simply match any changes in the money supply to economic growth. For instance, if GDP grows by 3 percent, increase the money supply by 3 percent to match (which leaves out lot of detail, but well describes the basic approach).

The Fed currently finds itself unable to pursue that kind of price stability, because its unemployment mandate gets in the way. The Fed can induce a temporary boom by unexpectedly boosting inflation. Businesses, surprised to see higher prices for their goods, will boost output and hire more workers, satisfying the Fed’s unemployment mandate. The trouble is that those hiring decisions were made based on artificially high prices arising not due to increased demand, but because of inflation.

Dishonest prices deny higher living standards to the poor over the long run. The genius of markets lies in the flow of information about supply and demand that price signals make possible. Obscure the signal, and people get the wrong information. That leads to inefficient investments, which in turn lead to higher economic volatility and lower overall growth. That is why inflationary booms are always temporary, as workers hired during such booms created a labor supply glut instead of value for consumers. More productive employment for those workers and better use of the resources they use never come to pass.

Recession follows, and the Fed’s unemployment mandate makes it difficult for the central bank to resist monetary easing, leading to another inflationary boom—until the next crash. If the Fed truly wants to reduce poverty and inequality, it needs to get rid of its unemployment mandate, which was only imposed in 1977, over half a century since the Fed’s 1913 founding.

Yellen pointed out in her speech, “Owning a business is risky, and most new businesses close within a few years.” She’s right. And that risk is magnified if an entrepreneur doesn’t know whether the price signals she sees are accurate or not. What looks like the right decision at the time might instead be fatal to a small business. Yellen is also right that starting your own business can be the most effective way to rise out of poverty. If the Fed tinkers with interest rates and the money supply in an effort to reduce inequality, it puts further obstacles in the path of entrepreneurs, and hurts the very people it intends to help.

If there is a guiding principle to effective Fed policy, it is that simplicity is beautiful. A complex, contradictory, unpredictable, and unstable triple mandate does the poor no favors. If the Fed’s seeks to maintain a stable, predictable, and honest price system as its sole monetary policy objective, it will do more to lift people out of poverty than any double or triple mandate.