HOPE I´M WRONG ABOUT THE BERNANKE FED / BARRON´S

Thursday, September 24, 2009

UP AND DOWN WALL STREET DAILY

Hope I'm Wrong About the Bernanke Fed


By RANDALL W. FORSYTH

The Fed's cred would be hurt by a hint of politically inspired targeting of the jobless rate.

HAS A POLITICIZED Federal Reserve begun to target the unemployment rate?

That is one inference that may be drawn from the monetary policy decision of the Federal Open Market Committee after its first meeting since President Obama's surprisingly early renomination of Ben Bernanke to a second term as Fed chairman.

I hope it is the wrong one.

In an otherwise ho-hum announcement, the FOMC would maintain its policy stance of a 0%-0.25% target for federal funds and continue "exceptionally low levels of the federal-funds rate for an extended period," just as the panel said after its previous meeting on Aug. 12.

And while conceding the economy is likely to remain weak "for a time," the FOMC said it anticipated all the monetary and fiscal stimuli "will support a strengthening of economic growth and a gradual return to higher levels of resource utilization in a context of price stability. (italics by me)

Last month, the FOMC said it expected "market forces will contribute to a gradual resumption of sustainable economic growth in a context of price stability". (italics by me)

The difference between those italicized phrases would seem to be innocuous, but they're not.

"Higher levels of resource utilization" sounds like factory operating rates and other measures of slack in the economy. Such slack also is a factor in the so-called Taylor Rule, which seeks to calculate the correct level of the fed-funds rate based on inflation and capacity utilization.

But the phrase also refers to the level of utilization in the labor market -- that is, the unemployment rate.

Thus, instead of fostering "a gradual resumption of sustainable economic growth," an unequivocally desirable aim put forth in the August FOMC statement, the Fed now appears to be seeking a decline in the jobless rate.

What's wrong with that?

It is the pairing of the unemployment rate and the inflation rate, which is an apparent codification of the Phillips Curve -- the assertion that there is an inverse relationship between joblessness and prices.

That notion seemed to have been put to rest in the stagflation of the 1970s, which saw double-digit unemployment and inflation simultaneously, and the low-inflation growth with a steadily falling jobless rate in the two decades starting in the early 1980s.

Of course, the record shows that the Fed never raises interest rates until the unemployment rate has peaked and has started to trend lower. But it is another thing to announce such a thing overtly. The Fed has always couched its policy actions in terms of containing inflation, the priority of central banks for the past generation.

Moreover, as an academic, Bernanke had been a prominent advocate of "inflation targeting" for central banks, eschewing all other policy aims for price stability.

Indeed, the record of economic policy that seeks explicitly to target the unemployment rate almost inevitably ends up producing both higher joblessness and inflation. And, conversely, when the economy does recover, the expansion of payrolls ends up signaling higher interest rates and an inevitable renewed downturn. So, growth ends up being halting and hiring is restrained.

For all the opprobrium being heaped upon former Fed Chairman Alan Greenspan, he should be credited for recognizing in the 1990s that inflation is not caused by too many people working. (That he did not see he was stoking asset inflation even as the consumer price index was well-behaved is another matter.)

That this apparent reversion to Phillips Curve thinking comes only weeks after Chairman Bernanke's renomination to a second term also is troubling. Even if there were no quid quo pro, the Fed has to be above any suspicions of political malleability.

This would supersede the other, relatively pedestrian aspects of the FOMC's statement, which otherwise was basically unchanged except for extending the Fed's program to purchase up to $1.25 trillion of agency mortgage-backed securities and up to $200 billion of agency direct debt for three months to March 31.

Some former high Fed officials privately worry that the central bank's stature already has been diminished for its failure in preventing the excesses that resulted in the bursting of the credit bubble, which has levied a tremendous cost on the economy.

Thirty years ago last month, the Fed under Paul Volcker undertook a decisive but costly campaign to end the double-digit inflation that had debilitated the U.S. economy. Despite increasing opposition and even death threats, Volcker stayed the course of restoring price stability by paying attention to money, not the jobless rate. In the process, he also restored the Fed's badly tattered reputation.

If the Fed reverts to targeting the unemployment rate, it risks losing what's left of its credibility.

As I said, I hope I'm wrong about this.

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