The Fed

Ben Bernanke is a smart guy and a student of the Great Depression, too bad it appears that he's focused on the wrong decade. Allan Meltzer has a terrific editorial in today's Wall Street Journal wondering if the Fed is making the same mistakes from the 70s, which lead to stagflation, that is, focusing on unemployment and recession at the risk of increased inflation and depressed economic growth.

According to Meltzer the Fed is under a lot of outside pressure:

For Wall Street, the pressure for lower interest rates is based on a hope that bond and mortgage yields will decline and their losses will be limited. Often long-term rates fall when the Fed lowers short-term rates -- and since bond and mortgage prices rise when their rates fall, the losses of investors in these instruments will be reduced. For Congress and the administration, there is a need to show "concern" by doing something in an election year. These are not the concerns that should influence an independent central bank.

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After 1985, Fed policy kept inflation and unemployment low. The result was 20 years of growth, and three of the longest peacetime expansions punctuated by short recessions.

We should not throw this policy away. Federal Reserve independence is a valuable right which should not be discarded. The Fed should insist on its obligation to prevent inflation and sustain growth, not sacrificing inflation to lower unemployment before the election.

At the heart of this is a desire to avoid a "recession" and can be seen in the Fed's rate cutting actions and Congress' move to protect those who suffered from home loan defaults. The article wonders if the political desire to do something about those issues (cutting rates, stimulus packages and bailouts) is worth the longer term effects on the economy (higher inflation, higher unemployment, low economic growth). Or, as Robert Samuelson put it in a recent Washington Post editorial:

Naturally, no politician acknowledges the self-evident implication: that recessions, though unwanted and hurtful to many, are not just inevitable; sometimes they're also necessary to prevent the larger and longer-lasting harm that would result from resurgent inflation. Interestingly, many academic and business economists who have more freedom to speak their minds suffer the same deficiency. They treat every potential recession as a policy failure when it is often simply part of the business cycle. They thus contribute to a political climate that, focused on avoiding or minimizing any recession, may perversely aggravate inflation and lead to much harsher recessions later.

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But persistent inflation -- the general rise of most prices -- has only one cause: too much money chasing too few goods. It's not a random accident. The Federal Reserve regulates the nation's supply of money and credit. The Fed creates inflation and can control it.

Since August, the Fed has been under great pressure to ease money and credit. It has. The overnight Fed funds rate has fallen from 5.25 percent in early September to 3 percent now. Politicians are clamoring for the Fed to prevent a recession. Banks and other financial institutions want cheaper credit to enable them to offset losses on subprime mortgages. There is fear of a wider economic crisis if large losses erode confidence and, by depleting the capital of banks and other financial institutions, undermine their ability and willingness to lend and invest.

Unfortunately, the Fed shows signs of overreacting to these pressures and repeating the great blunder of the 1970s. Underestimating inflation then, the Fed repeatedly shoved out too much money and credit in a vain effort to keep the economy near "full employment." Now, the Fed has again underestimated inflation. It expected the economic slowdown to suppress inflation spontaneously. But so far, the lower inflation hasn't materialized, in part because, outside of housing, there hasn't been much of an economic slowdown.

It's true that the Fed is treading the proverbial tightrope. No one wants a financial crisis, but no one should want the return of stagflation, either. The American economy -- a marvelous but flawed engine of wealth -- periodically goes to speculative or inflationary excesses. If most of those excesses aren't given the time to self-correct, we may be trading modest pain today for much greater pain tomorrow. Trying to prevent a recession at all costs is a fool's errand that could ultimately backfire on us all.

The Fed is in a no-win situation at this point: the political environment is not favorable to "letting markets work," instead, "something must be done" since people are losing their house (nevermind that those same people knowingly put themselves into that situation with their home loans), or "we are in a recession, Fed do something about it." Bernanke risks losing all control of the situation as he tries to mollify the competing interests of the political environment and the desire of Wall Street. As the saying goes, when you try to please everyone, you end up pleasing no one.