Can Bernanke Get Inflation Right?

The role the Federal Reserve played in the creation of the current crisis shouldn’t be downplayed. The manipulation of interest rates played a star role in creating conditions for a bubble to form and pop. I don’t think they should be blamed as much as Judge Richard Posner claims, but they certainly misplayed the interest rate deck.

As such it is only normal that we wouldn’t trust everything the Fed says. Which is why Fed chairman Bernanke’s testimoney yesterday didn’t necessarily make me sleep better last night. The New York Times wrote:

Mr. Bernanke said that while the pace of the economic decline appears to have slowed, the Federal Reserve would probably keep interest rates at “exceptionally low levels for extended periods” because of persistent weakness in the labor market.

[…] Once the recovery begins, Mr. Bernanke said, the Fed will undertake the measures necessary to drain excess liquidity from the economy and prevent a flare up in inflation. “We are confident that we have the tools to raise interest rates when that becomes necessary to achieve our objectives of maximum employment and price stability,” Mr. Bernanke told the House Committee on Financial Services.

Here is the thing. In 2003, the federal funds rate was 1% and there was question of whether or not to raise it. The dot-com recession ended at the end of 2001, the economy was on the rise. And the interest rate did go but, but not very fast. The debate was centered around the fact that cheap money was driving the economic boom and raising the rate would hurt America’s competitiveness with the rest of the world. Of course the downside was that the low rate drove up commercial and residential real estate prices and created a bubble. Sure it is a lot easier to make the call on raising rates six years after the fact, but the reality is that the Greenspan Fed didn’t make the right move.

Now the Fed faces a new debate on interest rates. One the one hand, the lower rates say and the more assets the Fed carries on its balance sheets, the higher the likelihood for us to face inflation. The downside is though that to raise rates now could slow the recovery process in terms of investments. Bernanke says they have the tools, but will they make the right call?

Ultimately, it is better to have the Federal Reserve set monetary policy than Congress, but that doesn’t mean they are perfect or shouldn’t listen to advice.