World-System (1950-2010) What Impact is the Fed Having on the Dual Mandate?

It seems that the US Supreme Court (here) will not allow the Trump Administration to fire Fed Board members (to include the chair) at will in an attempt to control Fed policy. The Fed is independent for a reason: politicians clearly want lower interest rates to stimulate economic growth and that is not always the right policy action. In a prior post (here), I presented forecasts for the Fed Funds Rate (FFR) which is the Fed's primary policy measure and which controls interest rates. In this post, I will look at the question of how much impact manipulating the FFR has on the Fed's Dual Mandate: keeping both unemployment and inflation low. 

If the Fed is not doing a very good job of meeting the Dual Mandate, maybe Fed independence is not that important (we have lots of other things to worry about with the Trump II Administration). According to ChatGPT:

The Dual Mandate can be tested statistically for the period 1950-2010. The graphic above is a Shock Decomposition showing a one standard deviation impact of increasing the FFR on Unemployment (L.US.LU) and the Consumer Price Index (FP.CPI.TOTL.ZG)--data taken from the World Development Indicators (WDI).** The model that produced the graphic is presented below in the notes.

The first thing to notice from the graphic is that the effects of a one standard deviation increase in the FFR are (1) positive on both LU and CPI, (2)  larger on unemployment than they are on inflation and (3) after about 2 years, the FFR positive shock starts decreasing inflation (the LU shock is over after about 2 years). These results are, of course, reversed for a reduction in the FFR: both LU and CPI decrease but inflation comes back after about two years.*** However, these are all small effects. 

Large shocks to the FFR are not doing a lot.

Another function of the Fed is to regulate the US Banking System. Here, we know from the Great Depression, that large numbers of bank failures have a huge negative effect on the economy. In fact, before the US could become the World's Hegemonic Superpower, it had to get its Banking System (among other institutions) in order.

Indeed, Right-Wing politicians would also like to lift Banking Regulations, another reason to maintain Fed Independence.

Notes

For more information about data sources and state space models, see the Boiler Plate.

** All data are in standard score units for comparability.

*** Reducing the FFR has a limit called the Zero Lower Bound (ZLB), which is a major concern to the Fed Board of Governors. The closer they get to the ZLB, the less influence they have, and politicians are always pushing the FFR to the ZLB!

USL20 Dual Mandate Model