The Federal Reserve has two jobs: keep prices stable and maximize employment. This “dual mandate,” codified in the Federal Reserve Act, sounds straightforward. In practice, it involves navigating profound uncertainties and genuine tradeoffs. Here’s how I’ve come to think about it.

Why Target Inflation at All?

The case for price stability rests on several arguments. High and volatile inflation distorts economic decisions—it becomes harder to distinguish genuine price signals from general inflation, and resources get wasted on inflation hedging rather than productive activities. Inflation also redistributes wealth arbitrarily, generally from creditors to debtors and from those on fixed incomes to those who can negotiate raises.

But why 2%? This target, now standard among major central banks, represents a compromise. Zero inflation sounds appealing but creates problems. Nominal wages are sticky downward—workers resist pay cuts—so some inflation lubricates labor market adjustments. A zero target also leaves no buffer against deflation, which can trigger debt-deflation spirals and liquidity traps.

The 2% target emerged from New Zealand’s pioneering inflation targeting in the late 1980s and gradually spread. There’s nothing magical about the number; some economists argue 3% or 4% would provide more policy space with minimal additional costs. But changing an established target risks undermining credibility, so 2% has become entrenched.

The Phillips Curve: Dead or Alive?

The relationship between inflation and unemployment—the Phillips curve—underpins much of monetary policy thinking. The basic intuition: when unemployment is low, workers can demand higher wages, which firms pass through to prices, generating inflation. When unemployment is high, the reverse applies.

But the Phillips curve has behaved strangely in recent decades. Through much of the 2010s, unemployment fell to historically low levels while inflation remained stubbornly below 2%. Economists debated whether the curve had flattened, whether natural unemployment had fallen, or whether inflation expectations had become so well-anchored that temporary labor market tightness no longer generated sustained price pressures.

Then came 2021-2023, when inflation surged even as unemployment remained relatively low. Supply shocks clearly played a role, but the episode also suggested the Phillips curve hadn’t disappeared—it was just context-dependent.

My takeaway: the Phillips curve is a useful framework but not a stable structural relationship. The Fed can’t simply pick a point on a fixed curve. The curve itself shifts based on supply conditions, inflation expectations, and structural changes in labor markets.

The Dual Mandate in Practice

How does the Fed balance its two objectives? The answer has evolved over time.

Under Chairman Volcker in the early 1980s, the Fed prioritized crushing inflation even at the cost of severe recession. The “Volcker disinflation” succeeded in anchoring expectations but involved unemployment above 10%. Once credibility was established, subsequent Fed chairs could maintain price stability with much smaller output costs.

The pre-2008 consensus held that the best contribution the Fed could make to employment was maintaining price stability. This view downplayed tradeoffs: over the long run, inflation targeting would deliver both stable prices and maximum sustainable employment.

The post-2008 experience challenged this consensus. With inflation persistently below target and employment slow to recover, some argued the Fed should tolerate temporarily above-target inflation to accelerate job growth. This view influenced the Fed’s 2020 shift to “average inflation targeting”—committing to let inflation run somewhat above 2% after periods of undershooting.

Average Inflation Targeting: Innovation or Error?

The Fed’s flexible average inflation targeting (FAIT) framework, announced in August 2020, represented the biggest strategic shift in decades. The idea was to prevent below-target expectations from becoming entrenched and to provide more policy accommodation during recoveries.

The timing proved unfortunate. Adopted just before the largest inflation surge in forty years, FAIT seemed to justify the Fed’s initial characterization of inflation as “transitory” and its delay in raising rates. Critics argue the framework contributed to policy errors in 2021-2022.

I think the evaluation is more nuanced. FAIT was designed for a world of persistently below-target inflation and constrained policy space at the zero lower bound. That world may return—indeed, absent the pandemic shock, we might still be there. The framework may yet prove useful in future episodes.

But the episode highlights a deeper issue: central banking frameworks optimized for one set of conditions can become liabilities when conditions change. The Fed was fighting the last war (deflationary pressures) when a new war (supply-driven inflation) emerged.

The Employment Side

The Fed’s employment mandate receives less attention than inflation targeting, but it’s equally important. Several questions arise:

What is “maximum employment”? The Fed doesn’t target a specific unemployment rate because the natural rate varies over time. Instead, it looks at a range of indicators—labor force participation, wage growth, quits rates, job openings—to assess labor market conditions.

Whose employment? In recent years, the Fed has emphasized inclusive employment, noting that tight labor markets disproportionately benefit disadvantaged workers. This represents an evolution from purely aggregate measures toward distributional concerns.

Short-run vs. long-run tradeoffs? Pushing unemployment temporarily below its sustainable level can generate inflation, eventually requiring tighter policy and higher unemployment. The Fed must judge how much near-term employment gain is worth potential future costs.

Where I Come Down

After studying this extensively, I’ve developed a few convictions:

First, the dual mandate is the right framework. Single-mandate inflation targeting, as practiced by many central banks, underweights the real costs of unemployment and output gaps. Employment matters intrinsically, not just as a means to price stability.

Second, humility is essential. The Fed operates with incomplete knowledge about structural relationships, natural rates, and the transmission of policy to the real economy. Rigid rules will inevitably fail in novel circumstances.

Third, communication matters enormously. The Fed influences the economy as much through expectations as through direct interest rate effects. Clear, credible communication about the reaction function helps markets and businesses plan, making policy more effective.

The dual mandate asks the Fed to optimize two objectives with one primary instrument—the federal funds rate. It’s an inherently difficult task, and imperfect outcomes are inevitable. But understanding the logic of the framework helps make sense of why the Fed acts as it does, even when reasonable people disagree about specific decisions.