How Should Bernanke Manage the Fed?

On Thursday, the Senate Banking Committee will vote on Ben Bernanke's nomination to be reappointed as the head of the Federal Reserve. Expect fireworks, because the accusations against Bernanke are serious: that he failed to recognize last year's financial crisis before it took hold, underestimated it when it first hit, and has pushed the Fed far outside its traditional purview without allowing sufficient governmental oversight. His critics are bipartisan, ranging from conservative Republican Sens. Jim Bunning of Kentucky and Jim DeMint of South Carolina (Bunning says he considers Bernanke the "definition of moral hazard") to Vermont independent Bernie Sanders, a self-declared socialist, who has promised to place a hold on Bernanke's confirmation once it hits the floor, forcing Democrats to round up 60 votes to reapprove him. Meanwhile, after 26 years of trying, libertarian Texas Rep. Ron Paul finally succeeded in placing a public audit of the opaque Federal Reserve into a financial regulations bill. His Federal Reserve Transparency Act—better known as "Audit the Fed"—won passage on Friday with more than 300 cosponsors. Its Senate equivalent, sponsored by Sanders, has gathered 30 cosponsors so far.

This anti-Bernanke sentiment resonates outside of Washington. Polls show that nearly four in five Americans support auditing the Fed. There's much to audit; over the course of the past year, the central bank has done much more than simply set interest rates and regulate banks. Bernanke helped to engineer the Federal Reserve's multi-trillion-dollar financial rescue and has pushed back on oversight. The Fed has refused requests to reveal the recipients of $2 trillion in emergency loans. Now, politicians and a whole lot of others are calling for his head.

The debate about Bernanke is a diversion from the important conversation about macro-economic policy: how can the Fed ease unemployment, and to what extent should it risk inflation to do so? Instead, it is Fed economists, and their increasingly vocal critics, who are in the process of hashing out how to best help the fragile economy within the Federal Reserve's mandate of keeping prices stable, inflation reasonable, and employment high.

The tools are limited. With the federal funds rate close to zero, the Fed cannot lower it to further stimulate the economy. At some point, the central bank will need to raise interest rates, to rein in inflation and have room to maneuver in case the economy worsens. For now the bank is keeping the cost of money low for fear of panicking businesses and bond markets.

At the same time, unemployment is in double digits. Over the course of the recession, America has shed more than 8 million jobs. Normally, Congress might combat this problem through stimulus: spending the government's money to hire America's workers. But the government has already written a large number of checks to Wall Street institutions, and even if there is more money available, the White House and congressional leaders may lack the political juice to force through another big bill. That leaves the Fed keeping rates low, and risking inflation, in the hopes that a loose money supply will encourage more businesses to hire.

The natural tendency of Fed chairs in the past has been to focus on inflation. "Any central banker worth his or her salt has a tendency to be conservative on the issue of inflation," says Tim Duy, a University of Oregon economist and expert on the Federal Reserve. "It's easy to prevent deflation. It's very hard to stop inflation once it gets hold." Some in the Federal Reserve's district banks, like Charles Plosser, the head of the Philadelphia bank, have started sounding that alarm. "[The Fed] has maintained the federal funds rate near zero for just about a year now," he said earlier this month. "Without appropriate steps to withdraw or restrict the massive amount of liquidity that we have made available to the economy, the inflation rate is likely to rise to levels that most would consider unacceptable."

But other economists are pushing the Fed to tackle the issue of unemployment and the plight of American workers. Janet Yellen, the head of the San Francisco bank, last month warned against raising interest rates too early. "At some point, of course, we will have to tighten policy—and we certainly have the means and the will to do so," she said last month. "Until that time comes, though, we need to provide the monetary accommodation necessary to spur job creation."

Prominent economists have started to call on the Fed to continue with more unorthodox emergency measures on unemployment—namely, expanding "quantitative easing," or pumping money directly into the economy. Most notable are Joseph Gagnon, a former Fed researcher now at the Peterson Institute for International Economics, and Nobel Prize winner and New York Times columnist Paul Krugman, who argue that the Fed should recognize the insufficiency of governmental stimulus and offer a dramatic (read: $2 trillion) quantitative easing. That might stoke inflation, but will bolster businesses and thus job growth.

Bernanke hasn't yet shown his cards, though he has said he plans to keep interest rates low for an "extended period" and signaled that he leans to the more dovish side, even if he might not take on such dramatic measures. "It's hard to imagine [the Fed] being more dovish than what we've got," says Kevin Hassett, the director of economic policy studies at the American Enterprise Institute. But, "because of earlier unorthodox policy action on the part of the Fed, the scrutiny needs to be there."

Ultimately, even if Congress ousted Bernanke, as remote a possibility as it might be—Fed watchers note that his viable alternatives: White House economic adviser Larry Summers, chair of the Council of Economic Advisers Christina Romer, and Yellen, the San Francisco bank head, being the economists most often mentioned—likely would pursue similar courses of action. And the noisy political battle over whether or not to boot Bernanke is fundamentally a backward-facing one. His biggest error (missing the housing bubble) and biggest gamble (the massive Fed expansion) are behind him. Congress and Fed watchers instead should focus on the looming economic questions on the horizon.