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Tuesday, March 1, 2011

Changing the Federal Reserve’s Mandate: An Economic Analysis

Marc Labonte
Specialist in Macroeconomic Policy

The Federal Reserve’s (Fed’s) current statutory mandate calls for it to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.” Some economists have argued that the current mandate should be replaced with a single mandate of price stability. Often the proposal for a single mandate is paired with a more specific proposal that the Fed should adopt an inflation target. Under an inflation target, the goal of monetary policy would be to achieve an explicit, numerical target or range for some measure of price inflation. Inflation targets could be required by Congress or voluntarily adopted by the Fed as a way to pursue price stability, or a single mandate could be adopted without an inflation target. Alternatively, an inflation target could be adopted under the current mandate.

For at least the past two decades, bills have been introduced in Congress to switch the Fed’s current mandate to a single mandate of price stability. In the 112
th Congress, Representative Pence introduced H.R. 245, which would strike the goal of maximum employment from the mandate; it does not include an inflation target. Were a single mandate to be adopted in the United States, it would follow an international trend that has seen many foreign central banks adopt single mandates or inflation targets in recent decades.

Arguments made in favor of a price stability mandate are that it would better ensure that inflation was low and stable; increase predictability of monetary policy for financial markets; narrow the potential to pursue monetary policies with short-term political benefits but long-term costs; remove statutory goals that the Fed has no control over in the long run; limit policy discretion; and increase transparency, oversight, accountability, and credibility. Defenders of the current mandate argue that the Fed has already delivered low and stable inflation for the past two decades, unemployment is a valid statutory goal since it is influenced by monetary policy in the short run, and discretion is desirable to respond to unforeseen economic shocks. A case could also be made that changing the mandate alone would not significantly alter policymaking, because Fed discretion, transparency, oversight, and credibility are mostly influenced by other factors, such as the Fed’s political independence.

Discontent with the Fed’s performance in recent years has led to calls for legislative change. It is not clear that a single mandate would have altered its performance, however. Some of the criticisms, including lax regulation of banks and mortgages and “bailouts” of “too big to fail” firms, were authorized by statute unrelated to the Fed’s monetary policy mandate. The criticism that the Fed was responsible for the depth and length of the recession leads to the prescription that monetary policy should have been more stimulative; it does not follow that more stimulus would have been pursued under a single mandate. Whether or not the Fed allowed the housing bubble to inflate, it is not clear that a single mandate would have changed matters since the housing bubble did not result in indisputably higher inflation. Some economists believe that the Fed’s recent policy of “quantitative easing” (large-scale asset purchases) will result in high inflation. Since inflation has not increased to date, a single mandate would not have prevented quantitative easing. The Fed has discretion to pursue policies it believes are consistent with its mandate, and it has argued that quantitative easing was necessary to avoid price deflation. It could still make this argument under a single mandate.

This report discusses a number of implementation issues surrounding an inflation target. These include what rate of inflation to target, what inflation measure to use, whether to set a point target or range, and what penalties to impose if a target is missed.

Date of Report: February 25, 2011
Number of Pages: 23
Order Number: R41656
Price: $29.95

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