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The Fed's Hawkish Stance

In Sunday's New York Times, President Obama's former economic advisor, Christina Romer, implored the Fed to do more to stimulate the economy. In her argument for this policy she abandoned the usual hawk versus dove characterization of the Fed's Open Market Committee members and placed the members into two new groups, the empiricists and the theorists:
Empiricists, as the name suggests, put most weight on the evidence. Empirical analysis shows that the main determinants of inflation are past inflation and unemployment.
With inflation low and unemployment high, empiricists see little inflationary threat from further monetary easing. Theorists see much more to worry about:
Theorists, on the other hand, emphasize economic models that assume people are highly rational in forming expectations of future inflation. ... For theorists, any rise in an indicator of expected or future inflation, like the recent boom in commodity prices, suggests that the Fed's credibility is at risk. They fear that general inflation could re-emerge quickly, despite high unemployment.
She sides with empiricists and calls for more easing, a position I agree with. However, as she notes, even the empiricists are relatively hawkish, and if there is any evidence that inflation is becoming a threat, they will join with the theorists and raise interest rates to ensure inflation remains under control. Thus, the groups are relatively equal in their hawkishness, they simply differ on the degree to which inflation poses a threat at the present time.

Why such a hawkish stance among the members of the Fed? They are certainly wary about the expansive monetary policy to date and, while I don't think inflation is much of a worry right now, keeping a close eye of inflation indicators is certainly warranted.

But there is more to the hawkishness than worry about the Fed's expansionary policy to combat the recession. There is also the longer run issue of how the federal budget deficit might affect monetary policy. If the deficit is not reined in, and if interest rates begin to rise as the economy recovers - as they certainly will at some point, though not any time soon - then the Fed will need to decide how to respond. If the Fed keeps interest rates low, it runs the danger of monetizing the debt and causing inflation. But if the Fed allows the interest rate to rise, it will run the risk of slowing the economy. Thus, if the debt continues to grow and interest rates start to rise, the Fed won't have any good options, particularly if the economy is running at less than full capacity.

The hawkishness we are seeing presently is, in part, a signal to Congress that if they don't get the budget under control, they cannot count on the Fed to bail them out through inflationary debt monetization. The Fed is sending a very clear message that it will raise interest rates rather than let inflation become a problem even if that means slowing the economy and increasing unemployment.

But there is a danger here. Members of Congress may use this message about the difficulties deficits pose for monetary policy to bolster their efforts to pass budget reductions in the short-run that do very little to solve the long-run budget problem. For example, the GOP's proposal to cut $61 billion from discretionary spending through cuts in programs such as Head Start and Pell Grants will do almost nothing to solve the long-run deficit problem, which is driven primarily by rising health care costs, but it could slow the recovery substantially.

The Fed cannot allow itself to be pushed into debt monetization by Congress, so communication along these lines is appropriate. However, how this message is communicated is critical. There are some members of the Fed who believe that tighter fiscal policy is needed now - mostly the same people who are calling for tighter monetary policy. But, fortunately for the economy, they appear to be in the minority. Those Fed members who think that tighter monetary or fiscal policy is in the short-run will be harmful need to make it clear that although it's important to solve the long-run budget problem, short-run contraction could be harmful and it could actually work against fixing the long-run problem.

I don't mean to say that Congress should refrain from making plans to reduce the deficit now. If Congress can somehow deliver a credible long-run plan, one that kicks in once the economy is on firmer footing, that could bolster confidence and help in the short-run. Importantly, it could also give the Fed and fiscal authorities more breathing room to deal with problems that might arise in the future, say from an oil price spike.

But immediate cuts to programs that have little or nothing to do with the long-run budget problem will harm the recovery, give the public a false sense of security that Congress is making headway on the budget problem, and it will not avoid the need to address the long-run budget issue down the road. The members of the Fed who understand this reality must do a better job of letting the public know that the current budget proposals would dim employment prospects, do almost nothing about the long-run budget problem, and make it much more likely that the Fed will face difficult choices in the future.