When Should Fed Reverse Their Monetary Policy Course?

The Federal Reserve has been committed to using monetary policy to improve employment conditions.  This November 15th, 2010 WSJ Real Time Economics blog entry by Martin Vaughn discusses how the Fed should not ignore inflation in their efforts to boost a sluggish job market.  While acknowledging that the unemployment rate remains high, Federal Reserve Bank of Richmond President Jeffrey Lacker told a group of Advanced Placement teachers of economics warned that the Fed should not wait too long to keep interest rates low.  Dr. Lacker uses the analogy of the 1960s where stagnant economic growth led the Fed to keep interest rates low for too long of a period.  The result was staggering inflation that took over a decade to contain.

In our Principles of Macroeconomics course, we talk about the balancing act that the Federal Reserve plays when managing money supply.  On one hand, their goal is to enhance full employment, but that can sometimes compromise price stability, which is another stated goal of the Fed.  One of the main tools used to boost employment is to increase money supply.  Previously, they did this by buying U.S. bonds in order to drive the fed funds rate down to essentially zero.  With that method dried up, Bernanke called for two installments of quantitative easing, which I describe in my previous blog entry.  However, there is concern mounting that these actions will lead to more inflation.

It is my opinion that Dr. Lacker's main purpose of this speech is to convey the Fed's message that they are concerned with inflation to alleviate concerns from their trading partners and investors.  They certainly do not want to raise inflation expectations which could lead investors to take their funds from the stock market and U.S. Treasuries and shift them to gold and other commodities.  Also, China could decide to stop buying U.S. debt if there is no serious action toward controlling inflation and large budget deficits.  If both scenarios occur, then we will see higher interest rates and dimmed prospects on future economic growth.  The best case scenario is that the recovery gains momentum with improved holiday sales and an improved job market can withstand an increase in the fed funds rate.