The Stash

To Love, or Blame, the Fed?

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Ben Bernanke's moves at the Fed have rightly attracted much praise in the last month after better-than-expected GDP and unemployment reports pointed to the end of the Great Recession.

The latest signs of Fed-Love come by way of John Maggs at the National Journal's econ blog, which points to a new paper arguing for a "Fed-like approach" to budget-making. Maggs asks: "Should we and could we create a Fed for the budget?" (The paper is a highly-recommended read.)

Of course, Fed criticism hasn't abated that much. The latest evidence comes from this weekend's Jackson Hole macro-econ get-together. The most interesting critique came from Carl Walsh of UC Santa Cruz, who pointed to an inconsistency in the way the Fed says it will control inflation once the economy picks up steam.

The Fed has committed itself to keeping interest rates at close to zero for the foreseeable future in order to get businesses and consumers to spend more money now. Walsh, along with much of the current academic literature, argues that, "[b]y committing to reduce future real interest rates, the central bank is committing to generating an economic boom...This boom will generate higher inflation in the future."

But the Fed has steadfastly maintained it will keep inflation in check while keeping rates low. And the markets have been playing along, with indicators showing that businesses don't believe big inflation is coming. My interpretation here is that the Fed isn't committing itself to generating a boom so much as taking out insurance against a very bad outcome. Once the window of real vulnerability passes, the Fed will likely raise rates.

True, that means the boom Walsh refers to probably won't happen. But is that necessarily a bad thing? If psychology does play a big part in economic behavior, getting out of the boom-bust frame of mind doesn't sound like such a bad thing.

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