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Fed policy remains on hold

(MoneyWatch) COMMENTARY As widely expected, the Federal Reserve is keeping policy on hold, it said in a statement today after concluding two days of meetings. Interest rates are still expected to remain extraordinarily low through late 2014, and there is no change in the Fed's other programs to stimulate the economy, such as its program "to extend the average maturity of its holdings of securities" and reinvest principle as the assets mature.

The question is whether this is the correct policy. Presently, the central bank is missing its employment target, and it is also below its declared inflation target of 2 percent. The Federal Open Market Committee, which sets monetary policy, said in the statement that it "anticipates that subsequently inflation will run at or below the rate that it judges most consistent with its dual mandate." So there is no risk of overshooting the inflation target, according to the Fed, only a risk of undershooting it.

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If that's true, if the Fed is likely to undershoot both of its targets -- the committee believes that in the worst case it will only hit its inflation target, not exceed it -- then why not pursue more aggressive policy?

The answer, despite what the FOMC says about low inflation risks, is fear of inflation. In particular, it is the fear that inflation expectations will become unmoored. The Fed believes that expectations of inflation are largely self-fulfilling. If people expect prices to go up, they will take actions such as demanding wage increases, which will duly rise, and the expectation will be validated. Then, as inflation begins rising, that can lead to further increases in expected inflation that will also be self-fulfilling, and an upward spiral is set in motion.

Is this fear realistic? Some of us, myself included, think the Fed should overshoot the inflation target in the short-run, since that would stimulate the economy, and then bring inflation back to target once the economy nears full employment. But the Fed seems unwilling to tolerate even the possibility that inflation might cross the 2 percent threshold.

I think the Fed should have more faith in itself. It is still paralyzed by the 1970s, when the self-fulfilling inflation expectations scenario above played out to the detriment of the economy. But this inflation didn't just happen without the central bank's participation -- policy mistakes had a lot to do with the outcome. Does the Fed think it has learned nothing? Would it really stand by and watch inflation rates go into the double digits without taking corrective action?

If inflation expectations begin to rise -- and there's no sign of that presently -- the Fed has the tools to bring them back down again if it has the will to use them. Is that the problem? Is the Fed worried that it won't have the courage to bring down inflation if it is called for (which would likely slow the economy)? If the unemployment rate is still relatively high and inflation begins accelerating, would the Fed be unwilling to try to fix the problem?

If unemployment is still too high, there's no reason to fix the problem. That's the policy that is called for. The important question is what happens as we approach full employment, and I have little doubt that the Fed will take appropriate action in such a case. I just wish the Fed had more faith in itself. If it did -- if it was absolutely clear that the appropriate action will be taken as the economy reaches full employment -- then long-term expectations would not be a problem.

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