Can the Fed Reduce Unemployment Without Stoking Inflation?

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Federal Reserve Chairman Ben Bernanke glided smoothly through his first regular news conference the other day—an event both remarkable and unremarkable. It was remarkable for symbolizing the Fed's ongoing transformation from a citadel of secrecy into an agency that tries to explain itself to the public. "The original attitude . . . was that it was no one's business what they did—and if you wanted to figure it out, do so yourself," says economist Allan Meltzer, author of a history of the Fed. Until now, there had been no news conferences, a legacy of the tight-lipped past.

What was unremarkable is that reporters' questions focused on an old issue: How much can the Fed reduce unemployment without stoking inflation? Bernanke's bet is: a lot. He's embraced super-easy credit to cut the appalling 8.8 percent jobless rate; that's 13.5 million people, nearly half out of work for six months or more. Since late 2008, the Fed has held short-term interest rates near zero. To cut long-term rates, the Fed is buying gobs of Treasury bonds and mortgage securities: $1.725 trillion from late 2008 to March 2010; an additional $600 billion from last November through June. These purchases are known as QE1 and QE2, for "quantitative easing."

But there's a growing debate about whether all the pump-priming is helping recovery or simply fostering inflation. The economy's fate may hang on who's right. Studies by Fed economists are, not surprisingly, supportive. One estimated that QE1 and QE2 lowered long-term interest rates by about 0.5 percentage points and saved nearly 3 million jobs; the jobless rate otherwise could have approached 11 percent. Many private economists are less impressed; they suspect the benefits of QE1 faded with QE2.

Lending markets "were frozen" when QE1 started, says economist David Wyss of Standard & Poor's. Investors wouldn't invest. The Fed's bond purchases reduced fear and stabilized markets. QE2's impact is more muted, he believes. One claimed effect is the stock market's surge. The theory: Investors switched from low-yielding bonds to stocks. Sure enough, stocks are up about 30 percent since Bernanke signaled QE2 in late August 2010. But Wyss doubts that QE2 accounted for more than 4 percentage points of the gain. Strong corporate profits are the main cause, he says.

Meanwhile, inflation creeps up. Over the past year, the consumer price index rose 2.7 percent; six months earlier, the year-over-year gain was only 1.2 percent. Bernanke blames higher oil and food prices, reflecting temporary factors (the war in Libya, poor harvests) that may be reversed. The danger of an inflationary wage-price spiral, goes this argument, is negligible because unemployment is high and pay is stagnant.

Maybe. But inflation's dynamics might be changing. Here's why. The recession caused enormous factory and business closures; now, there's less capacity to meet rising demand. Companies have more power to raise prices; a depreciating dollar compounds the effect by making imports more expensive.

You can see this vividly in two industries: autos and airlines. Since 2006, General Motors, Ford and Chrysler have shut about 25 percent of their capacity, says economist Sean McAlinden of the Center for Automotive Research. Car "incentives" (a.k.a. price discounts) are shrinking—which means prices are rising. The same thing has happened with airlines. In 2009, they made the biggest percentage cutbacks in capacity since 1942; the number of daily domestic departures (24,798) in late 2010 was nearly 10 percent lower than in 2007. In March, domestic airfares were 11.5 percent higher than a year earlier.

The problem might become more widespread. The Fed regularly measures manufacturers' production capacity. From 2007 to 2010, it fell 5.4 percent. That's the largest drop since the statistics began being kept in 1948; the only other annual decline occurred in 2003 and was a scant 0.25 percent.

The Fed is attacked from both the left (for doing too little to create jobs) and the right (for doing too much and tempting inflation), notes former Fed vice chairman Donald Kohn. Bernanke aims for a middle course. One argument for a less secretive Fed is this: Investors, managers and workers who better understand the Fed's goals won't futilely try to defy them. The Fed's very commitment to low inflation will restrain wages and prices. Up to a point, this may be true. But public relations alone won't control behavior. Actions outrank intentions.

The lesson of the 1970s' great inflation (13 percent in 1980) is that once prices begin to rise consistently, they feed on themselves. The fallout is disastrous. People and companies can't plan for the future; recessions become more frequent. Unexpectedly high inflation would probably doom today's cheap credit policy. The Fed would have to raise rates. Criticism from both left and right would intensify. So, much is riding on Bernanke's bet: If he loses, we all lose.