New Ambush on Fed Credibility Could Spur Inflation

New Ambush on Fed Credibility Could Spur Inflation

Republican politicians complaining about excessive government interference in the economy have launched an open political attack on the Federal Reserve that could cripple the central bank’s ability to stabilize the economy in the future.

The vehicle for the campaign is a letter signed by 23 economists, academics, analysts, journalists and officials at financial firms criticizing the Fed’s recently announced plan to buy $600 billion worth of longer-term Treasury securities in hopes of stimulating the economy by lowering long-term interest rates. The quantitative easing plan, known as QE2, is the second time the Fed has tried to boost the economy in this fashion.

The letter, which said the asset purchases “risk currency debasement and inflation,” appeared in a full page ad Tuesday in The Wall Street Journal and multiple websites. The political denouncement of the Fed could undermine the central bank’s hard won credibility as an inflation fighter. Should that happen, longer-term interest rates could rise sharply, hurting U.S. economic growth, driving down the value of the dollar and causing the cost of financing government debt to soar.

Many economists give Fed policies credit for curbing the virulent inflation of the 1970s. Furthermore, since 1991 consumer price inflation has averaged less than 3 percent annually and in no year has it reached 4 percent.

Some conservative economists who disagree with the Fed’s action declined to sign the letter because they didn’t want to become part of a highly partisan political fight. Some of the economists who signed it say they don’t consider themselves partisan.
“I don’t know about Republican lawmakers. Truth be told, I am a registered Democrat. Sound monetary policy, to my mind, is neither Democrat nor Republican,” one signer, Gregory D. Hess of Claremont McKenna College, said in an interview. He has made points similar to those in the letter in the past.

In unusual on-the-record interviews with journalists, Fed Vice Chairman Janet L. Yellen and William C. Dudley, president of the New York Federal Reserve Bank, defended the central bank’s plan. “We have extremely high unemployment, which could last a long time,” Yellen said in a Wall Street Journal interview. “My forecast is that inflation is going to stay at very low levels for some time.” The Fed has been “given a mandate by Congress to try to achieve maximum employment and price stability. It seems to me that action is called for to try to do a better job achieving that mandate.”

Both Yellen and Dudley emphasized that the new policy was not intended to drive down the value of the dollar. “We have no goal in terms of pushing the dollar up or down,” Dudley said in a New York Times interview. “Our goal is to ease financial conditions and to stimulate a stronger economic expansion and more rapid employment growth.”

But Rep. Mike Pence of Indiana, one of the Republican politicians opposing the Fed action, was so exercised about the possibility that the Fed’s buying Treasury securities could lead to more inflation that he said he would introduce legislation to drop the jobs part of that long-standing mandate. “The Fed’s dual mandate has failed,” Pence said. “It’s time for the Fed to be solely focused on price stability.”

“The notion that the Fed should be indifferent
to unemployment is a terrible idea,
damaging to the economy.”

Democratic Rep. Barney Frank of Massachusetts, chairman of the House Financial Services Committee, told reporters that attempting to eliminate the employment portion of the mandate “would be a very dumb fight” for Republicans. “The notion that the Fed should be indifferent to unemployment is a terrible idea, damaging to the economy.”

Mickey Levy, chief economist at Bank of America, decried use of criticism of a particular monetary policy decision as grounds for a wide-ranging political attack on the traditionally non-partisan, independent central bank. “The politicization of the Federal Reserve and its monetary policy is really bad news. It hurts financial markets, the economy and may damage the efficacy of the Fed’s future policies.” When he first read of the attack, “I really cringed,” he said.  

Levy said the effort to discredit the Fed may have been a factor in what he called “another big selloff” in the bond market on Monday as interest rates rose. “If the Fed does lose credibility, its record of keeping inflation low would be at risk,” Levy warned.

In the past, most congressional complaints about the Fed resulted from raising interest rates to slow economic growth when overheating threatened to cause inflation to take off. The key argument for an independent central bank is that it would be less likely to give in to pleas from politicians to let growth and inflation get out of hand.

Economist Alan Blinder, a former Fed vice chairman who teaches at Princeton University, said in an interview that the letter “was wrong in all the particulars.” The large scale asset purchases “are not some wild new departure in monetary policy, and some monetary policy stimulus needed because there’s no fiscal policy stimulus, indeed some contraction.”

As for the claim that the Fed action is likely to lead to high inflation, Blinder said, “That is most unlikely. You see these things coming. Economies don’t turn on a dime. To think the Fed would allow a really serious inflation is to say they are incompetent.”

The Fed has no official inflation target, but Fed officials’ individual long-term goals range from 1.5 percent to 2 percent. Blinder said that the Fed “might get some overshooting” of that range, but nothing like “6, 8 or 10 percent. They are just not that incompetent.”