Fed Rethinks Stimulus At Exactly the Wrong Time

What is it about a budding economic recovery that seems to drive U.S. policymaking off the rails? We started out this week with a debate about President Obama's budget proposal that looked right past its job-creating potential to instead focus on how much spending it does or does not cut. As I wrote earlier, this is exactly not the question you ask in order to keep an economic rebound moving.

Now we hear that the Fed is joining this party of confused policymaking by considering a more contractionary monetary policy, motivated by a fear that maintaining today's low interests rates will unleash inflation. But just as this is not the time to be worried about deficits, this is also not the time to be worried about inflation: both fiscal and monetary policy in the U.S. needs to be turned on full-blast stimulus right now to solve the short-term unemployment crisis, and we can take care of the deficits/inflation risks later.

What's particularly surprising about the Fed's shift in focus toward fighting inflation is that the central bank has been, by far, one of the most responsible policymaking arms of the federal government in the wake of the recession. The low interest rates and quantitative easing policies that Bernanke has pursued have been exactly what was needed to make a dent in the unemployment rate. The reason these policies haven't been more effective is because austerity hawks in Congress crippled our fiscal policy.

But do the monetary policy hawks have a reason to fear rising inflation resulting from consistently low interest rates? If history is any guide, then absolutly not: in fact, the last time the Fed genuinely commited itself to low interest rates and an expansionary monetary policy, we saw amazing gains in employment without any significant hike in inflation.

The period I'm referring to is the late 1990s, when Alan Greenspan decided to keep interest rates low and was willing to hold off and see what happened with inflation. Jared Bernstein and Dean Baker's analysis of this period reveals that not only did unemployment drop significantly, but those on the bottom end of the labor pool actually benefited most of all:

The real hourly earnings of low-wage male workers, after falling at an annual rate of 1% from 1973 to 1995…grew 1.5% per year from 1995 to 2000.

The real wages of high school dropouts grew 1% per year after 1995, after falling at about that rate from 1973 to 1995.

This rise in income for the poorest families led to dramatic declines in poverty rates, especially for African American families, whose poverty rates fell 5.7 percentage points from 1995 to 1999 while the overall rate fell by 2 points.

Of course, we are recovering from a much deeper economic downturn today than we were in the late 1990s, but the benefits of expansionary monetary policy are clear -- these gains at the turn of the last century eroded steadily after the Fed shifted course and tightened monetary policy in response to the 2001 recession.

We shouldn't make the same mistake twice. The Fed should continue the expansionary monetary policy that it has wisely pursued thus far -- and our fiscal policymakers need to have their backs.