Fed's Faulty Policies Will Create Inflation, Not Jobs

Attention has been shifting to the Federal Open Market Committee to see what the future holds for the course of monetary policy. Many are worried about the future after the debt ceiling debate, the credit rating drop for the US, and the debt concerns in the eurozone.

Posted 08/23/2011 05:44 PM ET

Investors are worried about the solvency of many European governments and the future course of U.S. fiscal policy, especially after the protracted debate on the debt ceiling.

Now attention is focused on the Federal Open Market Committee for clarity regarding the future course of monetary policy.

But instead of providing clarity, the members of the FOMC are debating the fundamental questions of what the Fed can and should do to promote economic recovery.

The recent FOMC majority decision to keep interest rates near zero until at least mid-2013 will extend the Fed's easy monetary policy to cover a period of more than five years.

The duration and degree of monetary easing is unprecedented in the history of the U.S.

And in doing this, the Fed is underestimating the risk of higher inflation and overestimating its ability to bring the economy out of recession.

The majority view on the FOMC is flawed and carries serious downside risks to the economy. Monetary policy did not bring prosperity from the Great Depression, it did not undo the stagflation of the 1970s, it did not undo the lost decade in Japan and it will not likely create jobs now.

The Fed can — and should — conduct policy to promote financial stability, inhibit excessive risk-taking and foster low inflation.

This will do more to improve the economy than continuing monetary policy that appears to have done little to promote recovery.

Continuing easy monetary policy risks much higher inflation than the Fed acknowledges. Chairman Bernanke's speeches clearly state that he sees little risk of inflation.

He argues that high unemployment will prevent inflation from rising, and he also notes that forecasters expect low inflation to continue.

But our research, and that of others, shows that neither the unemployment rate nor inflation survey forecasts are useful predictors of inflation.

And the stagflation of the 1970s demonstrates that loose monetary policy generates high inflation even in the face of high unemployment and slack capacity.

Moreover, history shows that inflation expectations are notoriously hard to manage once the credibility of the central bank as an inflation fighter is lost.

The Volcker disinflation and the severe recessions of the early 1980s are painful reminders of the costs of reducing inflation when monetary policymakers lack credibility.

The Fed also has limited ability to grow the economy with further easy monetary policy.

Unemployment has been at or above 9% since mid-2009, despite the Fed's program of quantitative easing.

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