Fed Watch

The Federal Open Market Committee concluded its meeting Wednesday August 1 with no change in its policy. They stated the following.

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee expects economic growth to remain moderate over coming quarters and then to pick up very gradually. Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.

To support a stronger economic recovery and to help ensure that inflation, over time, is at the rate most consistent with its dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. . . . The Committee will closely monitor incoming information on economic and financial developments and will provide additional accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.¹

The Federal Reserve System has a responsibility to conduct policy to achieve maximum sustainable output and employment and to promote "stable" prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act.²

This dual goal is seen by some as contradictory. They believe that unemployment and inflation tend to move in opposite directions. A contradictory and commonly held belief is that the inverse relationship is at best temporary. The real impact of monetary policy is on inflation and the impact on output and employment is at best temporary.

If you believe the inverse relationship exists, then the lack of current inflation leads you to believe the Fed should be doing more to spur the economy and reduce unemployment. If you believe the impact of inflation is important and the impact on production is temporary, you are concerned that the Fed’s recent actions will eventually lead to inflation. July 31 marked the 100^th birthday of Milton Friedman. He died in 2006. Friedman’s research led him to believe that inflation is determined by the actions of the Fed and that the Fed has very limited ability to stimulate production and reduce unemployment.

The current Fed seems to be trying to have it both ways. Since inflation is low, they are pursuing an expansionary policy and are prepared to make it more expansionary. While at the same time they say, “Don’t worry, we can reverse the policy actions quickly if inflation becomes a problem.” This is exactly the sort of belief that Milton Friedman argued against. If he is right, we are eventually headed for trouble.

1. FOMC policy statement http://www.federalreserve.gov/newsevents/press/monetary/20120801a.htm

2. Fed policy targets http://www.frbsf.org/publications/federalreserve/monetary/goals.html