The Full Employment and Balanced Growth Act of 1978 charges the Federal Reserve with using monetary policy to achieve low inflation and a low unemployment rate. This is known as the Federal Reserve’s “dual mandate.”
Usually, only one of these mandates is pressing. When a recession occurs, such as during the 2008–09 financial crisis, the unemployment rate rises while inflation remains low or there is mild deflation. In this case, the appropriate monetary policy response is to reduce interest rates to stimulate the economy and bring down the unemployment rate. When the economy risks overheating, as it did in the late 1990s, the appropriate monetary policy response is to increase interest rates to prevent inflation from setting in. In this situation, the unemployment rate is low, so higher interest rates are not a significant concern for employment.
The Federal Reserve presently faces a dilemma, as labor market weakness and elevated inflation are occurring simultaneously. The unemployment rate, currently at 4.4%, remains low by historical standards. However, it has increased from 4.0% since January 2025. This uptick coincides with weak job growth since May 2025. The economy has added a total of only 93,000 jobs since then, which is about half of a typical month’s job creation in 2024. The higher unemployment rate and weak job growth signal that the Federal Reserve should cut interest rates.
The issue, however, is that inflation remains elevated. The Federal Reserve has a 2% inflation target, which reflects the average rate of inflation prior to the pandemic. Inflation is currently 2.8%, which may appear close to the target but remains meaningfully higher.
In the current economic environment, the Federal Reserve thus faces a difficult trade-off: fighting inflation at the expense of job creation, or supporting employment at the cost of higher inflation.
Because inflation measures the growth rate of prices, even small differences matter over time. Inflation of 2.8% compounds to much higher prices than inflation of 2%. For example, an item that costs $1 today would cost about $2.70 in 50 years at 2% inflation, but roughly $4.00 at 2.8% inflation. Elevated inflation therefore suggests that the Federal Reserve should increase interest rates to bring inflation back to its 2% target.
The problem is that if the Federal Reserve chooses to focus on one mandate—either unemployment or inflation—the other is likely to worsen.
If the Federal Reserve cuts interest rates to spur job growth, inflation will likely remain elevated or increase further.
If it raises interest rates to reduce inflation, job growth will likely weaken further. In the current economic environment, the Federal Reserve thus faces a difficult trade-off: fighting inflation at the expense of job creation, or supporting employment at the cost of higher inflation.
The Federal Reserve cut interest rates three times in 2025, with additional rate cuts expected in 2026. This suggests that the Federal Reserve is willing to tolerate higher inflation in order to address weakness in the labor market. Consequently, there is a high likelihood that inflation will remain a source of frustration for households in 2026.
