Thursday, May 3, 2012

Fed up with the full empoyment target?

The debate on Bernanke's views on inflation targeting -- whether it should be 2 or 4% -- as I noted in a previous post is peculiar, to say the least. After all the Fed has a dual mandate, and inflation preoccupations have to be tempered by the pressing question of unemployment. The preoccupation in some quarters is that the Fed has already accepted as a matter of fact that it has single mandate (see here and here). It seems to me that critics (e.g. Krugman, DeLong and others) are correct for the wrong reasons.

The graph below shows the effective Fed Funds rate in the last three recessions (represented by the shaded areas). The rate of interest falls in all three during or just before the recession.
Further, after the trough of the recession the Greenspan Fed took 46 and 35 months to start raising the rate in the previous two recessions. So far, 35 months after the last trough, the Bernanke Fed has not increased the rate. This time around it has done Quantitative Easing allowing for lower long term rates too, which was not done during the Greenspan era. If anything the Fed has done more now than under Greenspan, and unless you believe in the inflation expectations fairy, the old Eccles maxim is still true, monetary policy now is like pushing on a string.

So how is that critics of the Fed are correct and I believe that the dual mandate (full employment and inflation) is gone. Well look at the graph below. It shows the Fed Funds, again, with the 10 year Treasury bonds rate.
Notice that the Fed eventually raises the Fed Funds sufficiently to surpass the bond rate, and invert the yield curve. The point is to slowdown the economy, and avoid full employment. Even in the 1990s, when Greenspan allowed the bubble to continue and unemployment to fall below the then official limit of 6%, he eventually took action, when wages started to increase. Full employment has not been a target, but keeping workers demands for higher wages checked has been very much part of the reaction function. Jamie Galbraith has written about it (go here for a technical paper). So the Fed has a single target mandate, but is not an inflation target, it is a "fear of full employment target."

The Fed can do practical things like helping distressed borrowers (with defaulted or underwater mortgages), but it cannot directly increase spending, and in the absence of private spenders (domestic or foreign), or local governments, it must be the federal government. Bernanke is not the problem right now. Geithner is (and so is Congress).

PS: The New Keynesian view that if you increase expected inflation spending goes up is now defended by Brad DeLong. He says: "an extra $100 billion of quantitative easing boosts the expected price level ten years hence by 1%--and boosts expected inflation after the next decade by an average of 0.1%/year. That is enough to spur higher spending and a more rapid and satisfactory recovery." I'm not against QE per se, the idea of maintaining long term rates low. But the notion that it would lead to inflation (printing money generates inflation) and that expected inflation generates a boost in productive spending is clearly another confidence fairy story.


  1. Why don't you explain with some detail why printing does not necessarily create inflation (is it that velocity equation?) I know that if people don't spend inflation won't be high. Now, can the government do enough to boost aggregate demand? Like in Brasil there is PAC or something like that? I know its hard for Obama to get these big fiscal projects voted for in congress. Maybe he should do a mensalão and buy the votes? haha

    1. Ja foi feito em outro post, ver aqui

  2. About demand inflation.. if there is a demand shock, isn't there a time lapse when employment can't be risen due to simply time constraints, where the price would have to go up? I know it goes up and stays that way (most likely) meaning it isn't accelerating, but the inflation does occur?


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