The Fed’s Phantom Tradeoff

Earlier this month, the Federal Reserve cut its interest-rate target by 25 basis points, or 0.25 percentage points, bringing the range down to 3.5–3.75 percent. This was no routine decision. It passed by a contentious 9–3 vote: two Federal Open Market Committee members wanted to hold the target rate steady, while Fed Governor Stephen Miran favored a larger 50-basis-point cut. Chairman Jerome Powell called it a “close call.”

What justified this controversial decision? According to the Fed’s official statement, policymakers judged that “downside risks to employment rose in recent months.” The unemployment rate had “edged up” to 4.4 percent through September, and job gains had slowed.

But there’s an obvious problem: inflation remains above target. Core consumer inflation sits at 2.8 percent, well above the Fed’s goal of 2 percent. Yet the Fed eased monetary policy anyway, explicitly prioritizing employment concerns over price stability.

This looks like a textbook case of the inflation-unemployment tradeoff baked into the Fed’s dual mandate, with unemployment concerns winning out. But that tradeoff is a mirage—unless the central bank is failing at its job.

Congress requires the Federal Reserve to pursue full employment and stable prices. In theory, this gives the Fed flexibility to balance competing objectives when setting policy. In practice, it creates the illusion that any true balance exists. The apparent tradeoff between inflation and unemployment is an artifact of ad hoc monetary policy, not economic law.

The only way the Fed can maintain the dollar’s purchasing power is by stabilizing aggregate demand—total spending on goods and services. When the Fed does that, it achieves maximum employment as well.  Were the central bank to provide businesses and workers with reliable expectations about the purchasing power of money, markets would work effectively. Capitalists would make long-term investments. Workers and employers would negotiate contracts. Real economic coordination would create sustainable growth.

Under a clear, rule-bound monetary policy, labor markets would create as much employment as possible, absent market distortions. But when the Fed conducts policy on an unpredictable basis—cutting rates here, signaling pauses there, keeping markets guessing about the next move—it impedes workers’ and employers’ ability to coordinate. Uncertainty clouds economic decision-making. The Fed’s discretion thus creates the very instability that supposedly justifies its existence.

Monetary uncertainty would not be a problem with a rule-bound Fed of the sort Milton Friedman, F. A. Hayek, and James Buchanan advocated. If the central bank were fully committed to price stability, workers would know how much to demand in wages, and employers would know how much they could pay. Labor markets, guided by clear price signals in the form of wages and benefits, could put as many people to work as genuine consumer demand could support. Yet under our discretionary monetary policy regime, the tradeoff between price stability and employment rears its ugly head because policy unpredictability generates it.

The Fed’s December rate cut illustrates the problem. Faced with above-target inflation and a gradually rising unemployment rate, policymakers could not commit to either objective. They split the difference—and chances are we’ll get the worst of both worlds. The market doesn’t know what to expect about future inflation. Workers and employers are groping around in the dark. The three dissenting Fed votes signal deep internal disagreement about what monetary policy should even seek to achieve.

Powell’s own words betray the confusion. He said that rates are now “in a broad range of estimates of neutral value,” and that the Fed is “well positioned to wait and see how the economy evolves.” Translation: We don’t know what’s coming next, so we’ll keep our options open. That’s not a strategy. It’s a tacit admission that discretionary policy has failed.

We can’t end the inflation-unemployment ratchet without committing to fixed monetary policy rules. That means changing the Fed’s mandate. Congress should replace the Fed’s dual mandate with a single mandate: price stability. The only thing the Fed can really control is the dollar’s purchasing power. Employment, in contrast, is determined by factors beyond the central bank’s reach. Keep the value of the currency stable, and labor markets will sort themselves out.

A rule-bound Fed that clearly communicated its policy would enable markets to form rational expectations. Businesses and workers could plan with confidence. Price stability would facilitate productivity-driven prosperity rather than repeated boom-and-bust cycles. The Fed’s phantom tradeoff would disappear because it was never real to begin with. It was merely a symptom of policy dysfunction.

Seventeen years after the 2008 financial crisis, the Fed is still flying blind—improvising at each meeting, trying to fine-tune an economy it cannot possibly control. This is monetary policy by sentiment, not science. We can do better with settled rules than with extemporaneous discretion.