Friday, December 3, 2010

Changes coming for the Fed

Republicans are pressuring the Federal Reserve to shift away from the dual mandate of price and output stability and focus primarily on price stability. They argue as the Fed has focused on creating more jobs it has come at the possibility of higher inflation.

Most of the recent criticism has come after the announcement for a second round of quantitative easing. I am a bit baffled by the recent push for a single mandate of price stability. If the Federal Reserve had a single mandate of price stability, would monetary policy be any different from today. Bernanke, perhaps more than anyone else, understands the risk an economy faces in the event of a debt-deflation spiral. His research has been instrumental in helping policymakers understand the risks associated with a large decline in prices. Following the housing crisis, the U.S. consumer faced record levels of debt. If prices decline, debt increases in real terms. If the economy would have entered a period of 2-3% of deflation, the real interest rate would have increased by 2-3%. Wages would have declined while mortgage, car, and loan payments stayed the same. That is a receipt for a disaster. We would have experienced drastic increases in household and bank defaults.

As much as Republicans want to change the mandate of the Federal Reserve, it would not change how they have conducted policy. Inflation rates are well below their target of 2-3%. Greg Mankiw, a conservative economics has also voiced his opinion on the matter:
I am skeptical. If the Fed's mandate were different, monetary policy today might well be the same. That is, with inflation now below its target, the Fed could be pursuing QE2 even if it were operating under the proposed mono mandate. Looking ahead, the Fed believes that inflation too low, even deflation, is a larger risk than inflation too high, so it is engaging in expansionary policy to get inflation back on target.
In another post he says:
My view is that QE2 is a modestly good idea.  I say it is a "good idea" because, like Ben Bernanke, I am more worried at the moment about Japanese-style deflation and stagnation than I am about excessive inflation.  By lowering long-term real interest rates below where they otherwise would be, QE2 should help expand aggregate demand.  I include the modifier "modestly" because I don't expect these actions to have a very large effect.
I think Congress is looking for someone else to blame instead of focusing on their own problems. Instead of blaming the Federal Reserve for doing something, perhaps they should focus on using fiscal policy to improve the economy. They need to be finding way to increase spending, cut taxes today and reducing the national debt over the next ten years. Going after the Fed tells me they are trying to avoid more pressing issues.

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