Economists Divided on Fed's Performance

WASHINGTON, JUNE 19, 2008--The last nine months have been an exciting time for Fed watchers. In response to the U.S. housing bust and resultant credit crunch, the central bank has acted forcefully, lowering the federal funds rate by 325 basis points, lending to nonbank institutions, and orchestrating the JPMorgan Chase buyout of Bear Stearns. These actions raise the question of whether the Fed is moving in the right direction in its policy responses to the crisis and to the double dangers of recession and inflation. On June 16, a panel of economists met at AEI to debate this issue.

AEI resident fellow Desmond Lachman moderated the discussion, leading off by declaring the crisis "the largest housing bust that we've known in the postwar period" and noting that $3 trillion in household wealth has already been lost to falling home prices. As for the credit crunch, he said that "while there has been some improvement, certainly since the dark days of March, credit conditions still look difficult." In response to these challenges, Lachman thinks the Federal Reserve "has reacted to many of these shocks in a rather forceful and, I'd say, unorthodox way, resorting in some cases to measures that haven't been used since the 1930s."

Much of the debate centered around the tradeoffs of fighting recession or inflation. AEI visiting scholar Allan H. Meltzer, an eminent historian of the Fed, argued that through its recent actions, the Fed "went back to the foolish things they were doing in the 1970s, which was putting most of their weight on how to avoid a possible recession . . . and believing the inflation would be modest to mild." He said that Fed economists have placed too much emphasis on core inflation numbers (which exclude food and oil prices) rather than on general inflation. "Hardly anyone who looks at these questions can believe that the rise in energy prices and in food prices is transitory or temporary," he added.

Economic consultant Michael Prell agreed with Meltzer's concerns: "I've suspected for sometime that the Fed has been going overboard in its aggressive actions to address recession risks--in this process contributing to an inflation trend it has been underestimating."

Mark Zandi of Moody's Economy.com was more concerned about the risk of a serious recession, however, because he believes that the most recent statistics on the economy's productivity in the second quarter will be revised downward. "I don't think there's any reason why they should pull back on these facilities [the Term Auction Facility, the Term Securities Lending Facility, and long-term repurchase agreements] any time soon," he said. "They're needed."

AEI resident scholar Vincent R. Reinhart, until last fall a top monetary policy official at the Fed, expressed disapproval of the board's actions that he believes represent a departure from its traditional emphasis on long-term strategies, political independence, and neutrality. "I would argue that the Federal Reserve and other authorities in the United States have eroded the discipline imposed by these three core principles," he said. This could lead to negative policy consequences because "the cheap talk about being responsive to near-term macroeconomic events sets you up for disappointment down the road--or sets you up for making an inappropriate policy action because you're afraid of disappointing markets."

Looking ahead, most of the panelists agreed that the Fed should raise interest rates, but they disagreed about how soon and how quickly it should occur. Meltzer urged an immediate raise to the level where the real fed funds rate equals zero, Reinhart and Prell said that rates should be raised when the economic situation is more stable, and only Zandi said a rate hike should not be on the table in the near term due to recession risk.

--MEAGAN BERRY

For video, audio, the presentations from, and more information about this event, visit www.aei.org/event1737/. More information about AEI's Economic Policy Studies program is available at www.aei.org/economicpolicy/.

For media inquiries, contact Véronique Rodman at 202.862.4870 or vrodman@aei.org.

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