Middle East Conflict Intensifies Policy Uncertainty, Federal Reserve Faces New Test in Balancing Dual Mandates

The Federal Reserve typically needs to balance two goals when setting interest rates: price stability and full employment. The war in Iran has caused a significant increase in energy prices, along with a rise in the unemployment rate in February, which could lead to a conflict between these two goals. This may prompt the Federal Reserve to maintain interest rates at the meeting on March 17-18, but changes in economic conditions may exacerbate the divergence regarding whether inflation or employment is more important.

The Balancing Act of the Federal Reserve

Since 1977, the U.S. Congress has tasked the Federal Reserve with a “dual mandate” to promote full employment and maintain price stability to ensure a strong economy. Generally, when prices rise, the Federal Reserve will raise interest rates to curb inflation; when the unemployment rate rises, it will lower rates to reduce borrowing costs and promote employment.

However, in the past year, while the U.S. labor market has softened, inflation has remained high, partly due to the rapid price increases during the pandemic. Measures taken by former President Donald Trump to impose tariffs on a large number of imported goods may further drive up prices, although the Supreme Court struck down the legal basis for most of those tariffs, casting a shadow over the government’s tariff policy.

Meanwhile, the war in Iran driving up oil prices may increase global inflationary pressures. Supply chain disruptions caused by the war have begun to lead to delays in the delivery of imported goods, and higher fuel prices may prompt consumers to cut back on spending.

Federal Reserve Chairman Powell

The Goals of the Federal Reserve

Federal Reserve policymakers have never set a precise target for the unemployment rate, believing that a sustainable minimum level of unemployment can only be estimated and will change over time. Currently, the Federal Reserve considers this level to be around 4.2%. If the unemployment rate falls significantly below this level, the economy may face labor shortages and trigger price increases.

In contrast, price stability has been a widely discussed topic among the public. In response to the inflation surge of the 1970s, former Federal Reserve Chairman Paul Volcker stated that the ideal inflation level should be close to zero. Janet Yellen, during her tenure at the Federal Reserve, advocated that the central bank should tolerate moderate price increases to support wage growth and strengthen the labor market.

The Federal Reserve formally adopted a 2% inflation target in January 2012 and has adhered to it ever since.

The Challenges Facing the Federal Reserve

The dual mandate of the Federal Reserve is not common among central banks globally. Most central banks are only responsible for maintaining inflation at a specific level or within a given range.

In recent months, the Federal Reserve’s task has become more complex. In addition to uncertainties around tariffs and oil prices, tightening immigration policies are also reducing the labor force and consumers, making it harder to assess the unemployment rate level that the economy can withstand without putting pressure on inflation.

These contradictions are reflected in economic data. On one hand, key inflation indicators show that prices remain above the Federal Reserve’s target; on the other hand, non-farm payrolls unexpectedly declined in February, indicating that the labor market may be weaker than previously anticipated.

This puts the Federal Reserve in a dilemma: cutting rates too quickly or too much may exacerbate inflation, while maintaining interest rates may push the unemployment rate higher.

Does the Federal Reserve Have a Third Mandate?

The precise wording of the Federal Reserve Act, which established the Federal Reserve System in 1913, sometimes leads some to question whether the Federal Reserve actually has a “triple mandate,” as the law requires the Federal Reserve to pursue “moderate long-term interest rates” while achieving price stability and full employment. The Federal Reserve’s newest board member, Stephen Milan, mentioned this wording during his confirmation hearing in early September, drawing the attention of some bond market observers. They speculated whether Milan would advocate for the Federal Reserve to purchase bonds to lower long-term interest rates.

However, other officials are unlikely to support this approach. The Federal Reserve has never viewed it as a third mandate and generally believes that moderate long-term interest rates are a natural byproduct of achieving price stability and full employment.