Between A Rock And A Hard Place: The Federal Reserve’s Quandary

Damned if you do, damned if you don’t.  The Federal Reserve catches a lot of flack for its loose monetary policy and inflationary actions, and perhaps rightfully so.  There is little doubt inflation will accelerate over the intermediate future as years of too-low interest rates manifest themselves in the form of consumer price inflation.  Nobody really complained when real estate and stock prices were inflating to unsustainable levels, but not that the party is over, the finger-pointing as begun.  The Federal Reserve, as the architect of monetary policy and guardian of the dollar, is caught square in the middle of the mud-slinging.   

The Fed Isn’t To Blame

Things haven’t turned out quite as rosily as the Fed hoped, but I don’t think that means they should be maligned or dismissed as incompetent.  To the contrary, the Fed was put in a very difficult position by the tech bubble and subsequent stock-market collapse.  In fact, many would suggest it was a no-win situation to begin with.  The best the Fed could hope for was to minimize the failure.  Had they not lowered interest rates precipitously following the tech bust, the situation could have quickly degenerated into a deflationary spiral.  If the negative effects of deflation aren’t nearly as well-known as the adverse consequences of inflation, they are certainly more severe.  Even worse, there’s no known cure.  Falling prices lead to higher unemployment which leads to less money in circulation which leads to falling prices ad infinitum.

Faced with the prospect of debilitating deflation, above-average inflation doesn’t seem all that bad.  Furthermore, the cure for inflation is fairly well-known and easy to implement.  You just have to raise interest rates through the roof.  Sure, the short-term consequences of the cure are often severe, but are usually short-lived and result in little long-term damage to the economy.  The effects of deflation, on the other hand, can last for decades.  Indeed, the lost output inherent in a deflationary environment is gone forever, permanently lowering society’s standard-of-living relative to what it could have been.  It is no surprise that central banks the world over (not just the US Federal Reserve) exhibit a strong inflationary bias.  Central banks will choose inflation over deflation any day.

The Dual Mandate

Another factor helping to explain the Federal Reserve’s behaviour is the so-called dual mandate.  By act of Congress, the Fed has two primary goals:  to maintain price stability and maximize employment.  Unfortunately, these two goals are sometimes in conflict.  Full employment by its nature leads to increased prosperity and higher levels of  disposable income, which according to the basic concept of supply and demand pushes up prices.  In a world where the Fed’s only mandate is to fight inflation, interest rates would be raised if unemployment got too low in an effort to counter inflationary pressures.  Of course, intentionally raising the unemployment level is extremely unpopular and the Fed would have a lot of explaining to do when members of congress start getting angry letters from their constituents.  Since inflation is usually less visible than unemployment, it’s politically expedient to trade inflation for jobs.