Why Fed inertia threatens the economy

(MoneyWatch) Pop quiz: The Federal Reserve believes the U.S. economy is A) Ready to surge; B) Growing steadily, but slowly; C) Sluggish; D) All of the above.

The last one, right. The central bank is all over the map on the state of the recovery. In the "ready to surge" camp we have Dallas Fed President Richard Fisher, who said Monday that "our businesses are poised to take off... . We're in awfully good shape, and we're in much better shape, I would argue, than our counterparts overseas." With the economy flexing its muscles, he opposes any further stimulus aimed at boosting growth. But with inflation under control, he's also against tightening interest rates.

Cleveland Fed chief Sandra Pianalto is among those central bank members who see steady, but not spectacular, economic gains. "Our economy is gradually improving, and while some uncertainty remains, I am seeing more evidence that our economic expansion is becoming self-sustaining," she told an Ohio business group yesterday, while conceding that on our present course it could take up to five years for the unemployment rate to fall to 6 percent.

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Like Fisher, Pianalto worries that further monetary easing could raise prices, while cautioning that it is too early to start hiking interest rates. As a result, she takes a similarly "wait and see" approach to managing the economy, arguing that the Fed's current policy stand is "still the one best-suited to foster steady gains" in jobs while keeping inflation in check.

In the "sluggish" recovery pew, we have Fed Chairman Ben Bernanke. Taking a dimmer view of the economy, he recently said that a persistent lack of demand is hindering growth and that "the job market remains quite weak relative to historical norms." (As my colleague Mark Thoma notes, that puts him in agreement with most corporate executives.)

Of course, Fed members frequently disagree in their views, especially over how to revive an ailing economy. Likewise, and as we were unhappily reminded during the period of malign neglect that preceded the housing crash, Fed members are also frequently in agreement -- and catastrophically wrong -- when the economy appears to be chugging along.

The result in both cases, whether because of dissent or group-think: Inaction. That's why some experts raise concerns about the central bank's current stasis. Betsey Stevenson and Justin Wolfers, two business professors at the University of Pennsylvania's Wharton School, express alarm over what could happen if the Fed mistakenly stands idle even as the economy hobbles along:

[T]he longer-run consequences could be dreadful, if we find ourselves with 8.5 percent unemployment fully six years after the recession began. Europe's experience in the 1970s and 1980s demonstrated that persistently high unemployment can become entrenched, leading to further unemployment in the future -- a process economists call hysteresis. Skills atrophy, hope fades and people lose contact with the networks that can help them find work. If this occurs with the millions of U.S. workers who have been without jobs for more than a year, it will be costly and very difficult to undo.

Consensus at the Fed isn't a requirement for wise policy. Still, the economy can't be "poised to take off," "gradually improving," and "weak relative to historical norms" all at the same time. Someone at the central bank is wrong. And how wrong could be the difference between a robust recovery that lifts all boats and a long, grinding drought that leaves most of us stuck in the mud.