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Home Publications Blogs Beat the Press The Fed Has Always Sought to Counteract Recessions

The Fed Has Always Sought to Counteract Recessions

Monday, 24 September 2012 04:21

The Washington Post has a piece on how Federal Reserve Board Chairman Ben Bernanke transformed the Fed so that it now has an active role in boosting the economy. In fact it is difficult to see anything qualitatively different about the role that Bernanke has set for the Fed. As the piece notes, high employment is part of its mandate. In past recessions, the Fed has sharply reduced the federal funds rate to help boost the economy.

FRED Graph

As can be seen, the Fed lowered the federal funds rate from 19 percent to 8 percent to boost the economy following the 1981-82 recession. It dropped the rate from 12.5 percent to 5.0 percent following the 1974-75 recession. The difference in this case is that the downturn is more severe and with inflation very low, the Fed has hit the limit of what it can do by lowering the federal funds rate since it is already zero. This has forced it to pursue extraordinary measures like quantitative easing and long-term commitments to keeping interest rates low. It is more the conditions which have changed rather than the Fed's role in the economy.

This piece also includes a line about the risks of the Fed's expansionary policy:

"The most significant [risk] is that the Fed’s efforts heat up economic growth in a way that unleashes inflation, which would eat away at middle-class incomes."

Actually it is very difficult to imagine inflation taking a form that would "eat away at middle-class incomes." If the economy heats up in the way described, it means that unemployment would fall sharply, leading to more rapid wage growth. This rapid wage growth would be the factor driving inflation. Since most middle income people get most of their income from wages, if wages are rising rapidly, it is unlikely that their income would be eroding. Most middle income retirees get most of their income from Social Security which is indexed to inflation, so these people would be largely protected as well.

The big losers from higher than expected inflation would be lenders, like the Wall Street banks, who have large amounts of loans outstanding that would suddenly be worth much less in a higher inflation environment. This is a reason why Wall Street is generally a forceful lobby against higher inflation.

At one point the piece refers to Bernanke's "grueling" years at the Fed. It is worth pointing out that the main reason the years have been grueling is that Bernanke and Greenspan failed to recognize the housing bubble (Bernanke was a Fed governor from 2002 to 2005) and to take steps to deflate it before it grew large enough to do so much damage to the economy. In other words, he is cleaning up his own mess.

Comments (4)Add Comment
Fear of full employment
written by Matias Vernengo, September 24, 2012 8:18
True, but the Fed also is very fast to change course when full employment approaches. Jamie Galbraith says that the Fed has a "fear of full employment target."
written by skeptonomist, September 24, 2012 9:10
What is really significant about the record of the Fed in the 80's is that it did raise its policy rate as high as 19% in a futile attempt to prevent inflation. In doing so it caused unemployment to go as high as 10.8%. This in combination with actual inflation (again; not prevented by the Fed) caused real wages to crash:


Thus: when the Fed attempts to prevent inflation by raising rates, the result in the real world is a decrease of real wages. In contrast, in the 40's and 50's the Fed did not raise rates in several inflation spikes, and wages kept rising. During WW II and the Korean war inflation was at least partly driven by labor shortage, so as Dean says real wage income was not harmed. The claim that the Fed needs to raise rates to prevent erosion of "middle-class incomes" is thus exactly contrary to what is shown by the historical record. A claim that the Fed prevents inflation by raising rates is also contrary to fact.
bernanke, a real piece of work
written by mel in oregon, September 24, 2012 4:30
bernanke follows randian alan greenspan in being responsible for the transfer of capital & lower salaries & wages for the poor & middle class. only a complete nitwit would argue that the fed's policies help anyone except the wealthy. that's why it's frustrating to have such a nonsense choice of obama vs romney. romney will accelerate the transfer of more wealth moving from the poor upward. obama will too, only not as rapidly. some choice.
J Horsley Palmer
written by Calgacus, September 24, 2012 6:54
Yup, skeptonomist.

The claim that the Fed needs to raise rates to prevent erosion of "middle-class incomes" is thus exactly contrary to what is shown by the historical record. A claim that the Fed prevents inflation by raising rates is also contrary to fact.

The crazy cult belief that raising rates MUST prevent inflation, MUST be disinflationary has been traced by Geoffrey Gardiner back to one http://en.wikipedia.org/wiki/John_Horsley_Palmer Not to criticize the estimable J. Horsley Palmer, but why are nearly all economists members of his cult? When centuries of evidence - Gibson's Paradox - argue against it? Sure, it can happen that way - but often, maybe usually, not. There are lots of effects going on in different, cancelling directions. Often enough, like right now, like during WWII, low T-bond rates should be disinflationary, not the reverse. QE is probably anti-expansion, just like it was in Japan, for which the name was coined.

As you say, the Fed became high priests of the cult in the 60s, starting with the "independence" granted by the misbegotten Treasury-Fed accord. The high interest rates of the 70s/ early 80s probably increased inflation in the long run. The rate lowerings that Dean extols were just the Fed half-repairing the enormous damage they had just done themselves - which had increased both inflation (maybe) & unemployment (definitely).

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About Beat the Press

Dean Baker is co-director of the Center for Economic and Policy Research in Washington, D.C. He is the author of several books, his latest being The End of Loser Liberalism: Making Markets Progressive. Read more about Dean.