The Fed meets a Fork on the Road to Oz. But is it an illusion?

These days the Fed sounds discombobulated. One Fed official says that we have to start thinking about withdrawing monetary stimulus and the next day another Fed official worries publicly that the economy is still too weak to contemplate raising interest rates above 0.25%. Bernanke always claimed that he would know when to withdraw the stimulus – and he would! Darn right! Like Bernanke I always know when to have my last JD of the evening but on occasion I sometimes have another one or two more as a night cap. It would be rude to not offer a night cap to good friends. Bernanke may have the same problem and the recent lack of unanimity of Fed officials underscores the real problem he has. In this post I try to do two things. First, explain why he will continue to have a challenge with the night cap thing and second, why there are good ways around this dilemma that involve mostly fiscal policy. But excuse me for a moment, as I can’t seem to find my JD.

That’s better. Now where was I? Night caps and Fed policy. Expansionary policy and government entitlements have a lot in common. Once you let the cat out of the bag it wants to stay out of the bag. You give a borrower a low interest rates and he will sacrifice two goats and a short child (this is Indiana the home of John Wooden) to keep those rates low. How unfair to raise interest rates just when the average family decides it wants to expand its family room to house its Best Buy nineteen surround sound speakers and 70 inch 3-D Samsung TV set. Imagine all the companies basing their expansion plans on a low cost of capital who might be forced to defer these investments because the Fed raised rates to 1%! Do you think for a second that once the Fed leaks more than a faint rumor of monetary tightening that Bernanke won’t hear a deafening moan and cry of why it is still TOO SOON to reverse monetary thrust?

Larry Dear – it is 11 pm and it is time for us to go home. But Honey Dear – there is still some onion dip residue on the corner of the coffee table and the host says we should stay and talk more about the pros and cons of using Coyote piss to control deer feeding in our backyard. It would be impolite to leave while some of the lights are still on. You might think I am crazy but this is what you are already hearing. The recession was over 7 quarters ago. 7 Quarters? If I remember my math correctly that is almost two years ago that we started the recovery. Consumer spending grew by more than 4% in the fourth quarter of 2010. And yet, the Fed is following through with another $600 billion in monetary stimulus. Geez, I’d hate to see Bernanke with a bottle of JD. Charles Evans, President of the Federal Reserve Bank of Chicago said on March 28, 2011

“Despite recent improvements to the outlook, we are not yet at that point” when “a change in the stance of monetary policy will be necessary,” Evans said today in the text of a speech in Columbia, South Carolina. “Slow progress” in lowering unemployment “and underlying inflation trends that are too low lead me to conclude that substantial policy accommodation continues to be appropriate.”

Geez Chuck, please tell me when it is time to shut the lights out. One analyst says that unemployment will not reach former lows until 2019. Are you going to wait until then? Everyone sees shoots of inflation popping up here and there. Are you going to wait until it is spreading like a wildfire to get out your hose? Please tell us if you can – how high does inflation have to be before you think it needs your attention? For how many months must it ravage us before you deem it a national problem? If inflation does start rising while the unemployment rate is still 9% or higher, then my buckaroo, what are you going to do then?

And this brings us to the fork in the road and my second point. It is well-known and pretty much correct that when the unemployment rate is high and the inflation rate begins to rise, this creates a VERY DIFFICULT TRADEOFF for the Fed. Remember that the Fed has one tool and this tool can only be applied to AD in one way at a point in time. If unemployment is the main problem today then it uses monetary policy to expand demand output, and employment – knowing that the negative consequence might be higher inflation. Instead, if inflation is public enemy #1 on another day the Fed will use its policy to reduce AD with resulting lower inflation – knowing that the negative consequence of slower growth might be higher unemployment.

So this is what we mean by the fork in the road. The Fed is at or very close to this fork when unemployment is still above 9% and the inflation rate is starting to rise. Toto (a dog) wants Dorothy to take the right fork and the Scarecrow (no brain) prefers the left direction. Dorothy has been traveling a long time and would just like to get to Oz where she can take off those tight shoes and have a very cold, shaken not stirred very dry Bombay Sapphire martini.

It turns out (and I am taking substantial liberties in this paragraph that could land me in real trouble with little people) that either one of those two paths is riddled with munchkins or evil witches or Joe Biden. Either path will get you to Oz but either path also has its negatives. But there is another path – a less popular one advocated by Macroman (no heart) that offers a clear and safe path to Oz. This path has no tradeoffs. This path decreases BOTH inflation and unemployment. The Scarecrow shouts that this is impossible. Toto pees on the Scarecrow’s stalky toes in concurrence. We pan our cameras to a scene with many dancers and singers – the refrain something like “we’re off to see the Wizard, and the Phillips Curve says there must be a tradeoff….” Or something like that.

But Macroman glides in on a broom and explains the glories of a shifting Phillips Curve – or more simply some brief words about why it is possible to reduce both inflation and unemployment. The Fed is in a fix. They say that they will refrain away from monetary expansion but they have already backed themselves into a no-win corner that offers very negative consequences in the short-run – either too much inflation or too much unemployment.

There is no better time to think about policies designed to reduce both inflation and unemployment together. These policies go to the heart of the business equation which says that reducing business costs and raising business productivity allows for simultaneously higher output, higher employment and lower inflation. Wow – is that really possible? It seems crazy because our policy makers are so stuck on the single horse we call AD that they cannot easily see or easily explain other policy alternatives. It may also reflect the fact that many of our legislators never took a course in microeconomics. Do you need a course in micro to graduate from law school? Sorry, all this Oz stuff (ie JD) is making me a little crazy.

By the way, these kinds of policies aimed at business costs and productivity are not novel or new. Virtually every transforming nation that moved from a centrally planned production system to a market driven economy legislated and implemented a host of policies aimed at strengthening business competitiveness. I won’t go through a list of things the US could do – at least not in this posting – but it takes very little imagination to understand these things. (1) Permanent increases in employment and prices come from firms. (2) Some government regulations and taxes may unnecessarily impose costs on business, and (3) constrain attempts to be more productive. I will let the politicians decide which of these things could be quickly evaluated and legislated.

My message is simple. Monetary policy officials are already too late to do what is necessary. They are still at the punch bowl. Monetary policy presently offers only bad choices with well known negative tradeoffs and consequences. There are other policies designed especially for these kinds of times and the Fed has no control over them. It would be better if the spotlight shifted from the Fed back to our government. The tools are there and they need to use them.