Public should speak up before Fed clamps down on jobs

The media often cover debates over Federal Reserve Board policy as though it is arcane and technical subject matter beyond the understanding of ordinary people. In this context we are supposed to take the statements of Fed officials as though they are pronouncements from Dr. Science, who “knows more than you do.”

In reality, the basics of Fed policymaking are fairly straightforward. The main question the Fed is considering right now is whether it should have its foot on the accelerator to try to promote growth and jobs, or alternatively whether it should have its foot on the brake to try to stop inflation. In the latter case, the economy will grow less rapidly and we will have fewer jobs and higher unemployment.

The Fed’s main policy tool is its control over short-term interest rates, which in turn affect mortgage interest rates, the interest rates on car loans and credit card debt and the interest rates that corporations have to pay when they borrow money. There is a real debate over how much the interest rates the Fed controls affect growth, but there is little question about the direction. Higher rates from the Fed mean slower growth and fewer jobs.

Given this background, when the Fed debates interest rate policy it is essentially asking whether there is such a high risk of inflation that it is necessary to slow growth and keep people from getting jobs. The answer to this question will depend both on what people think about the economy and how they view the cost of more unemployment versus the risk of higher inflation.  

In terms of the risks of higher inflation, if there is a Dr. Science, she is clearly not an economist. Economists’ track record in assessing the risk of inflation has been awful. In the 1990s there was near consensus across the political spectrum that inflation would become a serious problem if the unemployment rate fell much below 6 percent.

That proved to be completely wrong: The unemployment rate was below 6 percent for more than five years, reaching 4 percent as a year-round average in 2000, yet there was no inflation in sight. Thankfully, then-Fed Chairman Alan Greenspan did not share in the consensus of the profession and allowed the economy to continue to grow and the unemployment rate to fall.

Economists, including those at the Fed, did not do any better in the 2000s when it came to the housing bubble. Few had any clue as to the dangers it posed to the economy. The transcripts of the Fed’s meetings show that in 2007, even as the bubble was collapsing and the economy was falling into recession, many on the Fed were concerned that inflation could pick up. They argued for higher interest rates.

There is no reason to believe that economists have a better understanding of the economy today than they did in the 1990s or in the last decade. Those who warn of the risks of inflation are really just engaged in guesswork. And many of these people have been guessing wrong for the last four years, warning of an inflation explosion that we have yet to see. Instead, the core inflation rate, the one the Fed targets, is still running at close to a 1.5 percent annual rate, 0.5 percentage points below the Fed’s target.

In short, there is no clear basis for the concerns about inflation that many economists, including some at the Fed, are raising in public discussions. Their obsession with inflation reflects a lack of concern with the downside of higher interest rates: lower growth and more unemployment.

In this respect it is important to recognize that the Fed’s decision-making process is unduly tilted toward the financial sector. The 12 district bank presidents who sit on the Fed’s Open Market Committee (FOMC) are chosen through a process that is dominated by the banking industry. The seven governors of the board are appointed by the president and approved by Congress — only five of the slots are currently filled — and also tend to be oriented toward the financial sector. For example, Stanley Fischer, the board’s current vice chairman, was vice chairman of Citigroup in the bubble years from 2002-2005.   

Given the excessive weight of the financial sector in the Fed’s decision-making process — and the lack of any firm foundation for decisions to raise interest rates and slow growth — it is crucial that the larger public make its countervailing voice heard.

Last month a coalition of labor and community groups organized protests at the Fed’s annual meeting in Jackson Hole, Wyoming. The protesters politely sought to engage the Federal Reserve Board officers and staff at the meetings and to express their concern that the recovery be allowed to continue.

This is exactly the sort of action that will be needed over the coming months and years if the public is going to offset pressure from the financial industry. The people on the FOMC know that they will have to answer to the financial industry if they don’t move aggressively to stop inflation. They should know that they will have to answer to the rest of us if they needlessly move to slow the economy and keep people from getting jobs.