Dear Bernanke: Stop Spinning Your Wheels

After another promising winter, America’s economic troubles are back yet again, and the usual suspects are getting most of the blame. The more convincing arguments center around Europe’s appalling failure to resolve its fiscal-monetary crisis, while the less convincing arguments center around President Obama’s supposedly “big government” policies.

Shirley Li/Medill School of Journalism

Ben Bernanke, the Federal Reserve chairman.


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The real problem, however, is the Federal Reserve, which values sub-2-percent inflation above economic recovery. As Slate blogger Matthew Yglesias put it, the Fed has sacrificed recovery “upon a cross of 2 percent inflation.” The U.S. has experienced a weak recovery because the Fed simply won’t allow a stronger recovery to take hold.

A robust recovery, of the kind experienced in 1933 or 1984, would necessarily be accompanied by a period of higher inflation. During the 1984 recovery, for example, inflation averaged over 4 percent. And inflation during the rapid 1933 recovery, when industrial production surged at an unprecedented rate, was even higher than that.

Yet today, with unemployment still well above even the more pessimistic estimates of the natural rate, the Fed has communicated, through both words and a woeful lack of action, that it would be undesirable for inflation to rise above a meager 2 percent. And as Europe’s crisis has worsened in recent weeks, market expectations of inflation have dropped below the Fed’s long-run target, indicating that monetary policy, even if judged only with inflation in mind — that is, ignoring the unemployment rate in violation of the Fed’s statutory mandate — is too tight.

Of course, many at the Fed — including chairman Ben Bernanke would argue that the central bank has already done a great deal, that monetary policy is already accommodative, and that the economy is weak despite the Fed’s gargantuan efforts. They would be joined by many Republicans, who would hasten to add that current policy is actually too accommodative, and that the Fed’s trillions of dollars of asset purchases are sowing the seeds of hyperinflation.

What these people seem not to realize — or, in Bernanke’s case, choose to ignore — is that monetary policy, particularly when nominal interest rates hit zero, is more about communication than action: what the Fed says is far more important than what it actually does.

If the Fed announced next week that it was buying an additional trillion dollars in assets, but said that it would only hold those assets for a month, the effect on the economy would be negligible. The reason is obvious; if you give someone a million dollars today while promising to take it all back tomorrow, he won’t go out and spend it. Indeed, this “expectations” argument is standard in economics, and is often cited by conservatives to argue that temporary tax cuts are ineffective at stimulating economic growth.

This is why quantitative easing has not been inflationary in Japan or the U.S. In both cases, the central bank communicated that its actions were temporary, meant to last only long enough to stop either deflation (Japan) or disinflation (U.S.).

Indeed, economist and New York Times columnist Paul Krugman has argued that the difficulty with quantitative easing is precisely the opposite of what many critics fear: central banks, with their inflation-hawk reputations, have great difficulty convincing the public and markets that their monetary injections are meant to be even mildly inflationary. Although it is questionable whether a truly determined central bank would have as much difficulty as Krugman claims, it is clear that communications and expectations management are key to the efficacy of monetary policy.

Those who express concern about the Fed’s “activist” policies and worry about the specter of imminent hyperinflation — a concern, it should be noted, that markets seem not to share — are missing the point. They have been distracted by the glittering spokes of a spinning wheel, not realizing that the wheel is suspended mid-air and not going anywhere. Quantitative easing is like that spinning wheel: lots of commotion with little movement. It is up to the Fed’s communications strategy to determine to what extent the rubber meets the road, and therefore how far the wheel actually travels.

So far, the Fed has communicated its desire that the economy not go very far, lest it push up the rate of inflation beyond its 2-percent target. Although there is certainly a point beyond which it is no longer worthwhile to trade higher inflation for a quicker recovery, the Fed has yet to lay out a coherent argument for why 3-percent inflation is worse than a decade of economic stagnation, which carries its own costs, including the erosion of worker skills, the increased fiscal burden associated with elevated unemployment, and the loss of potential output from underinvestment.

Even if the Fed were only charged with maintaining stable inflation, it would have failed to fulfill its mandate, as an inflation target implies equal time above and below target. Since 2008, however, inflation has rarely exceeded 2 percent and has frequently fallen short. Given the considerable downside risk to the economy posed by crisis in Europe and slowing growth in China, India, and Brazil, it is downright appalling that the Fed has chosen to consistently err on the low side. And given that the Fed is also mandated by law to balance low inflation with full employment, the central bank has displayed near-criminal negligence in its management of the recovery.

The Fed meets again next week. Let’s hope the deterioration in the economic outlook prompts a long-overdue gut check from Bernanke and his colleagues. Let’s hope they finally decide to stop spinning their wheels and get the economy moving — for real this time.

Alexander Hudson is co-founder and Editor-in-Chief of Partisans. He was previously a Fulbright Scholar to the United Kingdom, based at the University of Oxford. He is currently a Ph.D. candidate in chemistry at the University of California, Berkeley.