The Fed was in over its head. It didn’t know enough to do what it (and many others) thought it could do. Today’s problem is similar. Although the Fed has learned much since the 1970s — including the importance of low inflation — its economic understanding and powers are still limited. It can’t predictably hit a given mix of unemployment and inflation. Striving to do so risks dangerous side effects, including a future financial crisis.
For proof of the Fed’s limits, look to the Fed itself. Since the 2008-09 financial crisis, which the Fed didn’t anticipate or prevent, it has repeatedly miscalculated. It’s made heroic efforts to revive the economy, including keeping short-term interest rates near zero since late 2008 and pumping out more than $2 trillion by buying mortgage bonds and U.S. Treasury securities. But as Chairman Ben S. Bernanke conceded last week, the Fed has consistently overestimated the recovery’s strength. Even if the Fed’s policies were right, their impact has been exaggerated.
Throwing money at the economy has produced only modest gains. The money paid out to buy bonds has aimed, through reinvestment in the stock and bond markets, to boost stock prices and lower interest rates on other bonds. These changes are intended to stimulate spending. Many economists agree that more can be done. “Is the Fed running out of steam? To some extent,” says Mark Zandi of Moody’s Analytics. “But interest rates on 30-year fixed mortgages are 3.35 percent. They could be lower.”
What might doom the Fed’s ambitions?
One threat is irrelevancy. Credit is arguably so easy that the Fed can’t do much more. Psychology counts. “What I see among small- and medium-sized businesses is rampant pessimism,” says economist Allan Meltzer of Carnegie Mellon University. “With $1.5 trillion of excess bank reserves, it’s hard to argue that there’s a shortage of loanable funds.” Fears about the “fiscal cliff” — all the tax increases and spending cuts scheduled for early 2013 — amplify this point.
Premature inflation is another danger. The conventional wisdom is that inflation will remain tame, suppressed by the large pool of unemployed (who keep wages down) and surpluses in most industries (which keep prices down). Competition works. Top Fed officials forecast 2013 inflation between 1.3 percent and 2 percent.