The Fed Has Always Sought to Counteract Recessions

Print
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.