A ‘Responsible’ Fed Could Hurt the Recovery

Janet Yellen, vice chairman of the U.S. Federal Reserve Photograph by Sam Hodgson/Bloomberg

Most of the time we want our central bank to be responsible. But sometimes—when the economy conks out and the jumper cables don’t work—the smart thing for a central bank to do is to “commit to being irresponsible,” (PDF) in the phrase of Gauti Eggertson, until recently a staff economist at the Federal Reserve Bank of New York.

Being irresponsible means trying to engender a bit of inflation, which ordinarily is anathema to a central bank. The idea is that the economy won’t begin to grow until businesses and consumers lose their fear of deflation, i.e., falling prices.

Under Chairman Ben Bernanke, the Fed hasn’t exactly started singing “Call Me Irresponsible,” but it has kept the short-term interest rate it controls on the floor and bought trillions of dollars of securities to bring down long-term rates. That has scared the heck out of inflation-phobes. The extreme measures seem to be working. “The economy is coming back to life,” says Lawrence Goodman, president of the Center for Financial Stability, a New York think tank.

But now, with inflation still low and unemployment still high, some voters on the Federal Reserve’s rate-setting committee seem to be getting squeamish about the Fed’s campaign. They think it’s irresponsible. That came through on Wednesday, when minutes were released from the January meeting of the Federal Open Market Committee. The most surprising sentence was this:

“A number of participants stated that an ongoing evaluation of the efficacy, costs, and risks of asset purchases might well lead the Committee to taper or end its purchases before it judged that a substantial improvement in the outlook for the labor market had occurred.”

It’s true that the Fed’s extremely easy monetary policy is risky. It could be inflating bubbles in the stock and bond markets while harming people, such as retirees, who depend on the money from their fixed-income investments. But it’s also true that yanking stimulus too soon could cause the economy to sink back into a torpor, as has happened several times in Japan during the past two decades.

Tim Duy, a Fed-watching blogger at the University of Oregon, says he’s concerned that the Fed is giving itself a convenient exit door from stimulus by saying on Feb. 20 that it will take into account “readings on financial developments.” Writes Duy: “‘Readings on financial developments’ is a pretty open-ended concept.”

But economist Michael Gapen of Barclays Capital notes that the Fed minutes also include more dovish remarks. He writes: “We characterize the debate as fairly balanced.”

In a note to clients, Paul Ashworth, chief U.S. economist at Capital Economics, says he’s hoping the Fed’s position will become clearer when Bernanke gives his semiannual testimony to Congress next week.

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