Edmund Andrews asks a good question. If the Fed is not worried about inflation problems down the road, and if a tradeoff exists between unemployment and potential future inflation, why not push potential inflation a bit higher in return for a lower unemployment rate?:
Those job numbers, by Edmund L. Andrews: Let's stipulate right up front: it's silly to infer much from one month of job-creation numbers. The numbers bounce erratically, they are often revised dramatically one month later and they routinely defy the consensus forecasts by a wide margin.
Last month, forecasters were surprised and the media were elated when the Labor Department reported that job losses dwindled to just 11,000 in November -- much lower than expected (and revised today to a net gain of 4,000). The newly exuberant forecasters were surprised again on Friday, when the estimated job losses in December jumped back up to 85,000.
"U.S. Job Losses Dim Hopes for Quick Upswing," declared a headline in The New York Times. I'm not sure how much hope there was for a quick upswing, but I'm even less convinced that the new job numbers change the picture all that much.
But here's what's interesting: the Fed's policy under Ben Bernanke seems intentionally geared to high unemployment for the next several years.
In a fascinating recent analysis, Laurence H. Meyer of Macroeconomic Advisers tried to model the Fed's decision-making as it carries out and eventually tries to unwind its extraordinary effort to juice up the economy. ...
In theory, the Fed is supposed to aim for full employment and stable prices or very low inflation. But Meyer points out that the forecasts of Fed policymakers anticipate that unemployment will remain well above 9 percent through the end of 2010 and well above 8 percent through the end of 2011 -- even though they expect inflation to remain very low. ...
In theory, the Fed could reduce unemployment more quickly by printing even more money, buying even more securities and driving down long-term rates even further. If you believe that "full employment" is about 5 percent, as the Fed does, unemployment would probably have to drop quite a bit from its current level of 10 percent before inflation became a threat.
So why not do it? Meyer theorizes that Bernanke &Co. believe that there are other costs to letting the Fed's balance sheet balloon in size. We don't know what those costs might be, but it's not hard to imagine some of them: a huge carry trade, as foreigners borrow dollars and lend in other currencies; the risk of new asset bubbles in strange places; chaos in financial markets when it comes time for the Fed to unwind its purchases.
The reality is that this economic crisis has been so severe that it will take time to rebalance, rebuild and perhaps repent. Lest we forget, Americans have still lost a massive amount of wealth in their homes, and the average household balance sheet wasn't pretty in the first place. Why should anyone expect consumer spending, previously our main source of growth, to rebound? Likewise, the banks still have huge loads of troubled loans on their books, which they refuse to come clean about but worry about nonetheless.
It's tempting to wonder about what would happen if the Fed really decided to flood the country with money. Its easy to understand why Democrats are looking for new ways to prop up the economy with fiscal policy. Even if unemployment peaks at current levels and starts to edge down, each month that it remains high will seem more grueling than the month before. But my hunch is there is a limit to quick fixes, and this will require patience.
There is one other reason the Fed might be skeptical about the impact such a policy would have. Lowering the long-term real interest rate creates an inducement for businesses to invest more in plants and equipment, for households to purchase houses or other long-lived physical assets such as cars and refrigerators, and so on. But if businesses and households do not act on the inducement -- and they may not if businesses have considerable unused productive capacity and lots of idle equipment, or if businesses and households are pessimistic about the future -- the policy will deliver the potential for future inflation without doing much to help with employment.
I think that the Fed could lower the long-term real interest rate with aggressive action, my questions are about the link between changes in interest rates and changes in business investment, and in spending on consumer durables/houses. I am not convinced that a fall in long-term rates will do much to increase spending quickly and have the desired impact on employment. If that's the intent of the policy, there are, I think, more certain ways to make this happen through rebates and other mechanisms such as an investment tax credit.
We've already seen that programs to encourage the the purchase of cars and houses can move consumers to action. Though the cash for clunkers and inducements for new home buyers may not have been the optimal programs (I'd argue they were far from optimal, but note that lowering real interest rates subsidizes many investments that would have been made anyway, and that is one of the main criticisms of these programs), these two programs did show that fiscal policy actions have the ability to induce changes in behavior. Effectively targeted fiscal programs provide a much more certain path to stimulating output and employment than through lowering long-term interest rates with monetary policy (inducements tied directly to hiring new workers could also be helpful, even better is for fiscal policy to create the demand itself through direct spending on infrastructure, etc. rather than trying to create behavioral inducements).
Fiscal policy can do the same thing as monetary policy, it can lower the price/payments on physical assets to encourage purchases, but it can do the job in a much more targeted and hence effective manner. As I've said again and again, I don't think inflation (more precisely potential future inflation) is a problem and I do not object to policymakers pushing a bit on this margin. I just have doubts about the response in a deep recession to the inducements that are created when interest rates fall, and I would like to see the effort augmented with substantial fiscal policy actions targeted at the same problem.