2015 Series • No. 15–3
Research Department Working Papers
Designing a Simple Loss Function 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 and to give their central banks a clear mandate to pursue price stability and instrument independence to achieve it. Advances in academic research supported a strong focus on price stability as a means to enhance the independence and credibility of monetary policymakers. An overwhelming majority of these central banks also adopted an explicit inflation target to further strengthen credibility and facilitate accountability. One exception 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." Although the Fed has established credibility for the long-run inflation target, an important question is whether its heavy focus on resource utilization can be justified. The authors' reading of the academic literature is that resource utilization should be assigned a small weight relative to inflation under the reasonable assumption that the underlying objective of monetary policy is to maximize the welfare of households inhabiting the economy. Woodford (1998) showed that the objective function of households in a basic New Keynesian sticky-price model could be approximated as a (purely) quadratic function in inflation and the output gap, with the weights determined by the specific features of the economy. A potential drawback with the large literature that followed is that it focused on relatively simple calibrated (or partially estimated) models. In this paper the authors revisit this issue within the context of an estimated medium-scale model of the U.S. economy, specifically the Smets and Wouters (2007) model.
Key Findings
- The authors find that the role of the output gap should be equal to or even more important than the role of inflation when designing a simple loss function to represent household welfare.
- 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.
- These results hold up to the introduction of 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.
Implications
Looking at measures of economic activity seems to be more important than previously recognized in academia and in policy circles. This result is particularly relevant to economies affected by nontrivial real rigidities and inefficient shocks, thus displaying a relevant tradeoff between stabilizing inflation and economic activity. Responding vigorously to measures of economic activity is a robust policy, in the sense that it would deliver good economic outcomes even in the absence of relevant policy tradeoffs. The authors' results make the case for a stronger response to measures of economic activity even during normal times.
Abstract
central banks' objectives, simple loss function, monetary policy design, Smets-Wouters model