It was big news last week when the Federal Reserve announced that it wants to maintain its current low-interest rate policy until unemployment, now 7.7 percent, drops to at least 6.5 percent. The Fed was correctly portrayed as favoring job creation over fighting inflation, though it also set an inflation target of 2.5 percent. What was missing from commentary was caution based on history: the Fed has tried this before and failed — with disastrous consequences.
By “this,” I mean a twin targeting of unemployment and inflation. In the 1970s, that’s what the Fed did. Targets weren’t announced but were implicit. The Fed pursed the then-popular goal of “full employment,” defined as a 4 percent unemployment rate; annual inflation of 3 percent to 4 percent was deemed acceptable. The result was economic schizophrenia. Episodes of easy credit to cut unemployment spurred inflation, which inspired tighter credit that boosted joblessness. By 1980, inflation was 13 percent and unemployment, 7 percent.
The Fed was in over its head. It didn’t know enough to do what it (and many others) thought it could do. Today’s problem is similar. Although the Fed has learned much since the 1970s — including the importance of low inflation — its economic understanding and powers are still limited. It can’t predictably hit a given mix of unemployment and inflation. Striving to do so risks dangerous side effects, including a future financial crisis.
For proof of the Fed’s limits, look to the Fed itself. Since the 2008-09 financial crisis, which the Fed didn’t anticipate or prevent, it has repeatedly miscalculated. It’s made heroic efforts to revive the economy, including keeping short-term interest rates near zero since late 2008 and pumping out more than $2 trillion by buying mortgage bonds and U.S. Treasury securities. But as Chairman Ben S. Bernanke conceded last week, the Fed has consistently overestimated the recovery’s strength. Even if the Fed’s policies were right, their impact has been exaggerated.
Throwing money at the economy has produced only modest gains. The money paid out to buy bonds has aimed, through reinvestment in the stock and bond markets, to boost stock prices and lower interest rates on other bonds. These changes are intended to stimulate spending. Many economists agree that more can be done. “Is the Fed running out of steam? To some extent,” says Mark Zandi of Moody’s Analytics. “But interest rates on 30-year fixed mortgages are 3.35 percent. They could be lower.”
What might doom the Fed’s ambitions?
One threat is irrelevancy. Credit is arguably so easy that the Fed can’t do much more. Psychology counts. “What I see among small- and medium-sized businesses is rampant pessimism,” says economist Allan Meltzer of Carnegie Mellon University. “With $1.5 trillion of excess bank reserves, it’s hard to argue that there’s a shortage of loanable funds.” Fears about the “fiscal cliff” — all the tax increases and spending cuts scheduled for early 2013 — amplify this point.
Premature inflation is another danger. The conventional wisdom is that inflation will remain tame, suppressed by the large pool of unemployed (who keep wages down) and surpluses in most industries (which keep prices down). Competition works. Top Fed officials forecast 2013 inflation between 1.3 percent and 2 percent.
But what if they’re too optimistic? The Great Recession devastated many industries. Companies failed. Factories were shuttered. Investment continues to lag. Beginning in 2009, industrial capacity dropped for three consecutive years, according to Fed figures. Nothing like this has happened for decades. If the recovery accelerates, surplus capacity could shrink quickly. Companies’ pricing power might strengthen unexpectedly. Prices for cars, air travel and other goods and services might rise.
For the Fed, the dilemma would be clear. Should it keep its pledge of low interest rates until unemployment hits 6.5 percent? Or should it combat inflation before it gets out of hand?
A final worry involves a future financial crisis. The most obvious candidate is the bond market, where a “bubble” is often said to have formed. Bond prices have soared, reflecting the Fed’s huge purchases and heavy demand from private investors seeking a “safe haven” from erratic stocks. But the more prices rise, the greater the danger that they’ve reached artificial levels and are vulnerable to a steep sell-off. Households and financial institutions (pensions, insurance companies) would suffer large losses. Any panic might spread to other markets.
It’s seductive to think the Fed can engineer the desired mix of unemployment and inflation. And the motivation is powerful. About 5 million Americans have been jobless for six months or more. The present job market represents, as Bernanke said, “an enormous waste of human and economic potential.” But the Fed is bumping against the limits of its powers. Are potential short-term benefits worth the long-term risks? It’s a close call.