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Government, Politics & Issues

Commentary: The Federal Reserve should act against inflation

This article first appeared in the St. Louis Beacon: June 25, 2008 - The Federal Open Market Committee (FOMC) announced on June 25 that it would hold the interest rate on banks' overnight loans at 2 percent. It also warned that inflation will get more scrutiny in future meetings. What the economists on the committee fail to comprehend is that actions really do speak louder than words.

At a minimum the FOMC should have raised the short-term interest rate by 25 basis points. This small change is not big enough to really affect anything. It would have sent an important message, however. It would have signaled that the Bernanke Fed is intent on getting ahead of inflation.

Failure to act exacerbates growing concerns that fighting inflation is not a major concern for these policymakers. Although some have broken with the majority when rates were pushed too low and now as rates are not being increased, most FOMC members seem frozen by the complicated set of problems they confront.

The FOMC should have increased the federal funds rate and coupled that change with a policy statement showing a commitment to fighting inflation. This would have set the stage for a gradual increase in rates over the next year or so, getting rates back to their pre-recession fighting levels.

Some believe that the Fed simply would not engineer such a policy during the election season. Maybe not this Fed, but in a bold and necessary split with previous policy, Jimmy Carter's newly appointed Fed chairman, Paul Volcker, sharply raised interest rates beginning in October 1979. The recession that followed was not conducive to Carter's re-election: Ronald Reagan won a decisive victory at the polls. But Volcker also won a decisive victory: The inflation rate, and expectations of inflation, tumbled.

Today, the Fed's policy shift need not be as Draconian as in 1979. True, expansionary policies of the past five years have pushed inflationary expectations significantly higher. But monetary policy over the last decade is much less inflationary than it was during the 1960s and 1970s.

During the mid-1970s, many economists believed that the "monetary" rate of inflation -- that is, the inflation caused by monetary policy -- was about 5 or 6 percent. By the end of the decade, monetary policy had pushed the underlying rate of inflation closer to 8 percent. The OPEC-induced oil price shocks of 1973 and 1979 helped push inflation to double digit territory. Those "shocks" came on top of monetary inflation rates that were much higher than today.

Central bankers should not give the impression that they will raise interest rates every time inflation increases. A 25-basis-point increase in interest rates would have only an indirect effect on soaring gasoline and food prices. Nor would such an increase worsen our current economic malaise. The first rate increase in 10 months would, however, establish the Bernanke Fed as tough on inflation.

What economists learned from the 1970s is that policy actions cannot lessen an inflation that arises from soaring commodity prices. A widely held view emerged that the only sensible Fed policy is to keep the underlying, monetary inflation low. Failing to move rates upward now is eerily reminiscent of FOMC policy stumbles dating back about 30 years ago.

The current episode of increasing inflation and rising unemployment highlights the need for a more transparent policy. Fed policy actions over the past few years have sent conflicting signals. Policymakers loathe the constraint that announcing policy rules places on their actions. But an announced inflation target gives markets a guide to interpret Fed actions. As an academic, Bernanke championed such policy rules. As chairman of the Fed, will he make it happen?

Rik Hafer is a research professor and chair of the Department of Economics and Finance and director of the Office of Economic Education and Business Research at Southern Illinois University Edwardsville.

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