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The Federal Reserve and credibility

At this point, there's wide agreement that a bit of inflation would do the economy good. Ken Rogoff thinks so. Paul Krugman thinks so. Tyler Cowen is on board, and so is James Surowiecki.

But the Federal Reserve isn't. "Raising the inflation objective would likely entail much greater costs than benefits," Ben Bernanke said in August. "Inflation would be higher and probably more volatile under such a policy, undermining confidence and the ability of firms and households to make longer-term plans, while squandering the Fed's hard-won inflation credibility."

Here's the thing about credibility: It goes both ways. The Federal Reserve can lose credibility by doing something that hurts the economy. But it can also lose credibility by being unable to help the economy. As Ryan Avent says, the Fed "needs to demonstrate that it can generate inflation if it has to." Or, barring inflation, something else that will get us moving.

The Fed has an increasing credibility problem. The economy is in terrible shape, and the central bank knows it. Its Tuesday release twice admitted that inflation is below what the Federal Reserve needs to fulfill its mandate. It's being criticized by a variety of economists for timidity, including by former members of its own staff.

There is a difference between a Federal Reserve that doesn't act because it's afraid that its actions won't work or will have negative consequences and a Federal Reserve that cannot act because there's nothing it can do. But not that much of one. And it's getting increasingly hard to tell the two apart. More worryingly, if the Federal Reserve keeps letting things get worse, it will eventually need to intervene, and it will need to intervene when the economy is even harder to help, and the chances for failure will be even higher.

By Ezra Klein  | September 22, 2010; 9:10 AM ET
Categories:  Federal Reserve  
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The one's easy: the Fed will intervene after the November elections, especially if the GOP returns to power. Bernanke -- like every Republican from Snowe and Collins rightward -- falls in line each and every time. This is purely political move on his part, like each and every policy decision currently coming out of Washington. From now until the election everything will be dictated by the horse race.

I'm not sure why Lil' Ezra and his confreres don't get this.

Posted by: scarlota | September 22, 2010 9:20 AM | Report abuse

When the word "credibility" is used to describe a central bank it means a very specific thing. That is that the Central Bank is willing to adhere to its goals. It tends not to be two sided because in general inflation is politically preferred for growth and seignorage reasons. Now if the looks like the Fed when announcing a 2% inflation target but will accept a 1% rate there maybe credibility issues that pop up but we've never really been on this side of it (Japan might have had this issue to a degree).

Posted by: endaround | September 22, 2010 10:01 AM | Report abuse

Inflation is the refuge of the economics scoundrel.

For once, Bernanke is right. The inflation genie can be very hard to coax back into the bottle.

Posted by: msoja | September 22, 2010 10:05 AM | Report abuse

Does any one find is strange that positive annual inflation year after year after year is considered "price stability"?

Should we arbitrarily transfer a great deal of wealth from creditors to debtors?

And what of the long run consequences of inflation? Suppose we get a nice little multi-year burst of inflation. How do we then get rid of our high inflation rate in the future? Does the solution start with "r" and ends in "ecession"? If so, what good is that? Assuming the project works as advertised, and we're sitting at 5.5-6% unemployment in 2013, might we not be right back up to 8% in 2014 as the Fed returns to fighting inflation?

If we get Rogoff's 6% inflation for several years (per article), where will interest rates be? And as the sudden surge of inflation ends (likely accompanied by recession), what then happens to interest rates? To the banks? The banks might need another bailout, as such an environment would be hard to manage through (of course, banks could keep credit tight as the Fed's burst of inflation goes through, but that raises the question of how we get 6% inflation in a tight credit world).

What happens to pay packages? Do we expect workers to be bamboozled by money illusion, or do they start asking for 6%+ annual raises? What happens when the 6% raise goes through as the Fed is trying to get inflation back to 2%? Won't we be hearing the pundits lament "sticky wages" and ask for yet another round of inflation to solve that problem?

Inflation raises more questions than answers.

Posted by: justin84 | September 22, 2010 11:41 AM | Report abuse

"Inflation raises more questions than answers." posted by justin84

It certainly does. Not to mention that the Fed couldn't create inflation in this environment if it wanted to. However, things are being set up quite nicely for massive inflation about 5-10 years from now, so those who are feeling some nostalgia for the Carter economy just need a little patience.

Posted by: bgmma50 | September 22, 2010 12:28 PM | Report abuse

The Fed doesn't have to respond to any concerns right now because Democrats are in charge and they couldn't care less.

Posted by: michaelh81 | September 22, 2010 1:12 PM | Report abuse

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