A Bayesian interpretation of the Federal Reserve's dual mandate and the Taylor Rule

• DOI: http://doi.org/10.1016/j.rfe.2012.06.005
• Published date: 01 September 2012
• Author: Bluford H. Putnam,Samantha Azzarello
• Date: 01 September 2012

A Bayesian interpretation of the Federal Reserve's dual mandate and the Taylor Rule☆

Bluford H. Putnam ⁎, Samantha Azzarello

Chief Economist and Research Analyst, CME Group, Inc., United States

abstractarticle info

Available online 23 June 2012

JEL classification:

E40

E43

E52

E61

Keywords:

Dual mandate

Federal Reserve

Bayesian inference

Inflation

Employment

When the Federal Reserve was established by the US Congress in 1913, its charter mandated that the new

central bank “promote an elastic currency”and the institution was given extraordinary powers to serve as

a lender of last resort to the banking system. Congress was reacting to the cycle of financial panics that had

beset the country since the Civil War and had worsened with the Panic of 1907. Congress sought to find a

remedy to prevent runs on banks turning into full-fledged financial crises. The term “elastic”in the opening

words of the charter was intended to underscore the need for a robust banking system that could withstand

shocks and not collapse upon itself. There was no mention whatsoever of a dual mandate of promoting price

stability and encouraging full employment.

With prodding from the US Congress, the Federal Reserve became highly involved in the management of the

economy of the United States after WWII, focusing on inflation and full employment objectives. In 1993 Pro-

fessor John Taylor set forth an elegant and simple framework (aka, the Taylor Rule) for analyzing the interest

rate policy of the Federal Reserve in terms of its dual mandate.

This paper examines Federal Reserve behavior from the mid-1950s to 2011 through the lens of the Taylor

Rule. Our contribution is to use a dynamic linear model with Bayesian inference to update the evolution

through time of the key parameters surrounding the inflation and full employment mandates, using only

the information available to the Federal Reserve at each point in time. Our findings provide a more nuanced

quantitative view than is previously available in the literature of how the Federal Reserve shifted its manage-

ment of its dual mandate over time and in response to different economic challenges. Moreover, our research

leads to serious questions of how Federal Reserve decision making may change in the future, following the

financial panic of 2008, pointing toward numerous avenues for new research.

© 2012 Elsevier Inc. All rights reserved.

1. Introduction

After the Panic of 1907, the US Congress moved to establish a cen-

tral bank with the powers to serve as a lender of last resort and pre-

vent runs on banks turning into full-fledged financial crises. The

Federal Reserve came into being in 1913, and its charter mandated

that the new central bank “promote an elastic currency”. The term

“elastic”in the opening words of the charter was intended to under-

score the need for a robust banking system that could withstand

shocks and not collapse upon itself. There was no mention whatsoev-

er of a dual mandate of promoting price stability and encouraging full

employment. The dual mandate concept emerged after World War II,

as the US Congress reflected back on the Federal Reserve's near total

abrogation of its assigned duties in the 1930s with its failure to

serve as a lender of the last resort as had been intended.

Congress passed the Employment Act of 1946, and later the Full

Employmentand Balanced Growth Act of 1978 (Humphrey–Hawkins),

along withother amendments to the FederalReserve Act, which collec-

tively and over time enshrined the dual mandate of price stability

and full employment into law. Since the 1950s and well before the

Humphrey–HawkinsAct of 1978, the Federal Reserve had becomehigh-

ly involved in the management of the economy of the United States

to serve both inflation and full employmentobjectives.

In 1993 Professor John Taylor set forth an elegant and simple

framework (aka, the Taylor Rule) for analyzing the interest rate policy

of the FederalReserve in terms of its dual mandate. OurBayesian infer-

ence methodologyallows for a sophisticated and nuanced quantitative

perspective of how the Federal Reserve shifted its management of its

twin objectives over time and in response to the different economic

challengesit faced.

To highlight the research implications, our interpretation of our

empirical results suggests the following:

➢Our Bayesian approach broadly confirms that the Federal Reserve

pays active attention to balancing the inflation and full employ-

ment of its dual mandate more or less along the lines suggested

by the original Taylor Rule.

Review of Financial Economics 21 (2012) 111–119

☆The research views expressed herein are those of the author and do not necessarily

represent the views of the CME Group or its affiliates. All examples in this presentation

are hypothetical interpretations of situations and are used for explanation purposes

only. This research article and the information herein should not be considered invest-

ment advice or the results of actual market experience.

⁎Corresponding author. Tel.: +1 301 872 5200.

E-mail address: BLU@BAYES1.COM (B.H. Putnam).

1058-3300/$ –see front matter © 2012 Elsevier Inc. All rights reserved.

doi:10.1016/j.rfe.2012.06.005

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