Samuelson on the Fed

Economic Journal Robert Samuelson says the Fed should focus more on inflation, even at the risk of a recession here

His argument is as follows:

Electronic banking has largely erased the difference between checking and savings accounts. The interest rates that matter most to the economy -- on mortgages, auto loans and business borrowing -- are increasingly set in the market. Investors decide what they'll accept on bonds and "securitized" mortgages and other loans. The banking sector represents only 23 percent of lending. The impact of the fed funds rate has weakened. Rates on conventional 30-year mortgages (6.2 percent) are now what they were in mid-2004, despite a huge jump in the fed funds rate.

None of this renders the Fed powerless. It can still alter the economy's available credit. But the channels of its influence are more murky, indirect and unpredictable. It cannot steer the economy single-handedly, and many other forces (technology, business and consumer confidence, global money flows) matter as much or more. There is, however, one area where the Fed's power is unquestioned: inflation.

The greater economic stability of the past 25 years stems fundamentally from the fall of inflation -- 13 percent in 1980. The Fed engineered that decline, beginning with the deep 1981-82 recession (peak monthly unemployment: 10.8 percent). Since then the Fed has refused to supply the extra money and credit that would feed ever-worsening inflation.
The result: calmer business cycles

Keep in mind that support for this type of proposition relies on a long run argument. That is, short run deviations in (read recessions) do not alter the trend growth rate, which is determined by long run factors (some of which we will discuss on Micro.) Thus the Fed should give a greater weight towards inflation, since high and variable inflation will cause uncertainty and dampen growth, and underweight growth, since it is a short term problem.

This type of analysis depends heavily on how "long" you think the long run takes to occur. A more Keynesian type of economist believes that this long run can be rather "long" in coming. Some economists believe in hysterosis, which means that a recession can actually lower the long run growth path. Think of it this way. Say you are a computer programmer that loses his job due to recession. The recession may mean that you have to accept a lower paying job. Your pride will not allow you to do this, so you remove yourself from the labor force or take a lower paying job that maybe fun (school bus driver) rather than what your optimal production would be (computer programmer).

This probably holds for people in their 50's rather than 20's, however.

As a general reply, I will say that better monetary policy has been at least partly behind the smoother growth path, but better inventory management and technology has also played a role. It is an open debate whether Keynesian style management of short run fluctuations help in this regard. Personally, I think the monetary side of the equation is more promising than the fiscal side.