The Fed has a mandate to stabilize prices and provide for high employment. The Fed interprets that mandate as calling for 2% PCE inflation and an unemployment rate close to the natural rate. Tim Duy points out that the unemployment rate has recently fallen below the Fed’s estimate of the natural rate:

On one hand, the unemployment rate plunged 0.3 percentage points in November to 4.6 percent: . . .

This is below the range of the longer-run central tendency (4.7 – 5.0 percent), sufficient to prompt a preemptive rate hike in December without dissent.

For most of the past 8 years, the unemployment rate has been above the natural rate. How should policy change as inflation falls below this benchmark?

Here’s it’s easiest to start with the case where we have a simple inflation target—2% inflation, regardless of what’s going on in the economy. Under that regime the policy choice is simple—always aim for 2% inflation. Now let’s add a second goal, unemployment close to the natural rate. In that case, you still aim for 2% inflation when unemployment is at the natural rate. But when unemployment is high you adopt a bit more expansionary monetary policy than would be called for by a strict 2% inflation target, and vice versa. This means the Fed should aim for slightly above 2% inflation during high unemployment years, such as 2008-15, and slightly below 2% inflation when unemployment is below the natural rate—like right now, or during the housing bubble.

Is this the Fed’s actual policy? No. As far as I can tell, the Fed aims at something closer to the exact opposite—below 2% inflation during periods of high unemployment, and above 2% inflation during booms. On the face of it, this seems to violate the dual mandate. But since neither Congress nor the economics profession seems to notice this problem, there is no pressure to fix the policy. One reason I favor NGDPLT is that it would force the Fed to move toward a policy that it theoretically has already adopted, but in practice does not adhere to. A policy that is consistent with the Fed’s legally mandated policy goals.

PS. Don’t assume the takeaway from this post is about what the Fed should do today. The Fed’s problems run far deeper than today’s decision, which is relatively unimportant. Rather the Fed does not have the correct regime in place to deal with a turn in the business cycle. As long as we continue in this expansion, monetary policy will probably be roughly OK, and not a major concern for the economy. Our problems lie elsewhere. The problem is procyclical inflation.