The Fed’s Trade-Offs as It Navigates Inflation and Growth in 2024

A regular series on the choices faced by international economic policymakers

Recently, as progress against inflation has stalled, the dilemma over the U.S. Federal Reserve’s dual mandate has come back into focus. Unlike other developed country’s central banks, which focus solely on price stability, the Federal Reserve is unique. It has a dual mandate to promote price stability as well as maximum employment. This mandate was shaped in the 1970s, an era of simultaneous high inflation and unemployment, known as stagflation. The mandate was officially set by Congress in the 1977 amendment to the Federal Reserve Act, which explicitly set the Fed’s goals as “maximum employment, stable prices, and moderate long-term interest rates.” Stable prices and long-term interest rates are typically clubbed together as a single mandate and maximum employment is deemed the second.   

At times, the Fed’s choice of which of its two congressional mandates to focus on has been easy. During the Great Recession in 2008, it prioritized economic growth and employment by reducing its benchmark federal funds rate and discount rates to near zero, and expanded its traditional use of open-market operations to help stimulate the economy. The Fed took similar steps when the economy shut down in March 2020 due to the COVID-19 pandemic. Conversely, during the post-pandemic reopening of 2021–22, when inflation rose to four-decade highs, the Federal Reserve naturally prioritized its mandate of price stability. It raised its target federal funds rate from near zero in February 2022 to between 5.25 and 5.5 percent by July 2023, its highest in twenty-two years, where it has remained since.  

However, at other times, the Federal Reserve has faced trade-offs when choosing which of its two mandates to focus on. A good example is the dilemma it faces today. The Fed’s aggressive rate hikes have lowered Consumer Price Index inflation from its peak of 9.1 percent annually in June 2022 to around 3.4 percent as of the latest reading. Meanwhile the Fed’s preferred Personal Consumption Expenditures index fell from its peak of 7.1 percent in June 2022 to 2.7 percent in March 2024. However, this remains above the Fed’s long-term target of 2 percent. Moreover, disinflation appears to have stalled since last fall: the last mile, bringing inflation down from around 3 percent to the target 2 percent, has proved challenging.  

The Fed now faces two choices, each of which comes with trade-offs: Does it continue to focus on inflation and keep interest rates elevated to bring it down to its target of 2 percent, or does it shift its focus from inflation and gradually lower rates for the rest of the year in the hopes of a soft landing? 

Both options have costs. Leaving interest rates elevated for too long weakens interest-sensitive sectors such as housing and could trigger a recession. Conversely, lowering interest rates while inflation is still above target levels could entrench inflation in the economy. Further, if the Fed fails to get inflation back to its publicly stated target, it could undermine its own credibility, which is important for anchoring the public’s inflation expectations. Additionally, there is a distinct possibility that inflation could shoot up again soon, especially if the geopolitical situations in Ukraine or the Middle East take a turn for the worse.  

The Fed is likely to get around this, as it has in the past, by implicitly continuing to prioritize price stability for the moment, as it appeared to do when it left its target federal funds rate unchanged after its latest meeting. Holding rates higher for longer and delaying the start of an easing cycle is likely the better choice for the Fed. Prioritizing the inflation fight ultimately preserves the purchasing power of lower-income households. Allowing inflation to run at a higher rate than its publicly stated target could raise people’s long-term inflation expectations and risk making future bouts of inflation even more challenging to control. Whether the 2 percent inflation target is an appropriate one could be a question worth considering, but the Fed would prefer to shelve any such discussions until after the current bout of inflation is fully brought under control.  

The Federal Reserve’s dual mandate of price stability and maximum employment certainly leads to some trade-offs. However, despite the trade-offs it necessitates occasionally, the dual mandate has allowed the Federal Reserve to maintain balance in the economy and the United States to build and continue the economic primacy it has to this day.