Why is the Fed Hesitant to Do More for the Economy?

Last Updated Aug 25, 2011 6:52 PM EDT

Ben Bernanke is scheduled to give a speech Friday at the annual Federal Reserve conference in Jackson Hole, but I don't believe he will announce any major new initiatives such as QE3. I think he will be careful not to say anything that can be interpreted as an inclination to tighten policy sooner than is currently expected, so it may appear the Fed is leaning somewhat in the other direction,i.e. towards easier policy. But I'll be surprised if Bernanke goes beyond making it clear the Fed is willing to do whatever it takes to help the economy, i.e. he won't promise or even hint that any particular action is imminent.

To me, that is disappointing -- I believe the Fed needs to do more -- but it's not my decision. It does, however, bring up a question. With so many economists pushing for easier policy, and with Bernanke himself criticizing the Japanese for not doing more when they were in a similar position, why is the Fed unwilling to commit to further easing? Where does the hawkishness come from?

I think it's a combination of several factors.

First, some members of the board do not believe that monetary policy can do much to stimulate the economy, low interest rates or not, but they see the potential for large negative effects from inflation. Thus, there is little benefit from stimulative monetary policy and a large potential cost. These are the doctrinaire inflation hawks.

Second, there are also some who that believe monetary policy is effective in normal times, but much less so near the lower bound for interest rates (which we are at presently). Thus, again, an expected-benefit expected loss analysis generally comes up negative, i.e. the cost of inflation is high relative to the benefits.

Third, there is a fairly large group who believe it could work. But as Bernanke said in a speech not too long ago, this is uncharted territory for the Fed and they aren't sure what to expect in terms of inflation, etc. This uncertainly leads members of this group to assign a large spread to the potential costs -- they don't think inflation will be a problem, but a large outbreak of inflation cannot be ruled out and must be factored into the decision. But the clincher is the fear that if they do end up creating inflation, the Fed could lose its independence, particularly if there is little to show for it in terms of stimulating the economy. If they lose their independence, the response to every future recession would be less effective. This makes recessions more costly, and when the higher costs are tallied across all future recessions, the total cost of losing its independence is very high. Thus, this is a major stumbling block.

So the unwillingness to do more for the economy comes from a combination of ideological hawkishness, particular among the regional bank presidents, skepticism about the power of monetary policy, and uncertainty about the ability to control inflation that arises from being on unfamiliar ground.

But that is not quite enough. I think a majority on the FOMC would still push forward if it weren't for the change in the political environment. When Bernanke wrote earlier in his career and criticized the Japanese central bank for not doing more, I don't think he thought the consequences of being wrong about inflation were as severe as they are now. The Ron Pauls in Congress looking for a reason to attack and take away the Fed's powers, the criticism from many on the left for all sorts of things, etc.,etc., puts the Fed in a more precarious political position than they ever expected to be in, and the fear of making a mistake and losing independence is tying its hands. The Fed values independence first and foremost, and it is unwilling to put that in danger. Thus, the Fed is trading more unemployment now for less in the future, and it's mainly the political environment rather than economics that is driving this decision.



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