The U.S. Federal Reserve announced last week that it will keep interest rates near zero in an effort to assist a stumbling U.S. economy. While that news was expected, the length of the extension was not — the Fed plans to keep rates well below 1 percent for three more years.
The Fed also announced that it would set an inflation target of 2 percent to guide its decisions and those of other economic actors. The decision is a break with tradition and is part of Chairman Ben Bernanke’s efforts to make Fed decision making more transparent. It is a laudable goal and one that should facilitate its efforts to get the U.S. economy moving again in a sustainable manner.
After its first policymaking session of the year, the Fed said the U.S. economy was showing moderate growth, but was threatened by a depressed housing market and the prospect of another recession abroad. With the U.S. unemployment rate likely to remain at 8.5 percent for most of 2012, before falling to between 6.7 to 7.6 percent by the end of 2014, continuing the existing “loose money” policy — interest rates of 0 to 0.25 percent — makes sense.
The Fed justified the decision by noting that it would give equal weight to its twin goals of promoting maximum employment and promoting price stability. Historically, the Fed has appeared to put more weight on the second objective. Some economists have argued that fears of inflation have been disproportionate to the risks, and particularly misplaced when compared with the larger economic dislocations created by events since 2007.
In short, the real concern should be global depression; measures to choke off distant — if not imaginary — inflation only prolong existing difficulties.
The need for Fed action is only stronger at a time when politicians in Washington are deeply divided and unable to take action as a result of partisan divisions. Mr. Bernanke seems to understand his responsibilities, noting that the Fed is “prepared to look for different ways to provide support to the economy if, in fact, we have this unsatisfactory situation.”
The Fed’s efforts at quantitative easing — buying up mortgage-backed securities as an alternative way to inject liquidity into the U.S. market — is one of the unconventional ways it has tried to respond to economic uncertainty. Mr. Bernanke has conceded that more such efforts may be required, acknowledging that “expanding the balance sheet remains an option, one that we’d consider very seriously in particular if progress toward full employment became more inadequate or inflation remained exceptionally low.”
After the meeting, the Fed also announced that, in its estimation, inflation should increase at 2 percent per year on average. It has long been assumed that the Fed had an “inflation target” and that it ranged from 1.7 to 2 percent. The Fed announcement takes away the guesswork and makes its working assumptions more visible.
Announcing the official target brings the Fed into line with many of the world’s other central banks. It also continues Mr. Bernanke’s quest to make the workings of the Fed more transparent. Since he took office, he has promoted increased openness, making public the notes of Fed meetings earlier than before, holding more press conferences and speaking in much plainer terms than his predecessor, Mr. Alan Greenspan, known for his statement that “if I have made myself clear, I have misspoken.”
Unlike Mr. Greenspan, Mr. Bernanke believes that communications helps temper public expectations and allows for better planning by businesses. At the same time, however, he cautioned against taking any targets as absolute. Mr. Bernanke noted that “we are not absolutists” and that he and his colleagues will work to reach the appropriate balance among the Fed’s goals. “If there is a need to let inflation return a little bit more slowly to target to get a better result on unemployment, then that is something that we would be willing to do.”
That practical approach is needed. A devotion to targets divorced from the day-to-day performance of the economy is as dangerous as is a disregard of them. Targets, whether for inflation or unemployment, are just that.
While the decision to be more aggressive in fighting persistently high unemployment is laudable, there is danger in holding interest rates low: It threatens the livelihoods of those who rely on savings to live. A low Fed interest rate means low savings rates for ordinary depositors and those who live off income generated by pension funds or other investments.
The decision last week to hold interest rates at or near zero until 2014 means that this group will have enjoyed no growth in its savings for nearly six years. The squeeze will be intensified if inflation increases as anticipated.
This balancing act will be difficult, but it is not impossible. At a time of unprecedented dislocation, the Fed must focus on helping getting the U.S. economy moving and insulating it from the ripple effects of decisions elsewhere in the world. A stable and growing U.S. economy is in the interest of all other nations — especially when such stability seems to be in short supply.