How “Hard Won” Is The Fed’s Credibility?

Fixing recessions is easy. You need to reduce real interest rates to the point where desired savings match desired investment and the total flow of spending through the economy is sufficient to employ all resources. When interest rates are too high, you get underinvestment and idle resources. Nothing about this logic breaks down at the so-called “zero bound” on nominal interest rates. In the future when there is no paper money, you’ll just set a negative nominal interest rate. But in the present there’s still no zero bound on real interest rates because there’s no upper bound on the inflation rate. The case against ending the recession by cutting the real interest rate is, in the words of Karl Smith, that “if a sustained period of high inflation were allowed expectations would become unmoored and the Fed would loose it hard won credibility.”

Smith offers a theoretical argument that this won’t happen. But I’d like to add that the most illogical thing about this worry is that the Fed’s credibility wasn’t all that hard to win. What it took was a politically unpopular sustained period of high unemployment lasting from roughly January 1980 to November 1982. That was a bad scene. On the other hand, we’re now into the second quarter of our fourth straight year of severely elevated unemployment. The Fed’s forecast of the likely consequences of its current policy is that we have at least two more years of this to undergo. The idea that suffering through a seven-year depression is necessary becaus the alternative might force us into a two-year recession if everything goes badly awry doesn’t make sense.

The whole thing is like one of those scenes on House where one of his assistants suggests a treatment then another assistant raises the objection that the proposed treatment might kill the patient. Dr House always swoops in to remind them that not treating the patient will definitely kill him, so you have to get to work.