We Need a Scheme for Full Employment

Is the Fed breaking the law? That is a question that members of Congress should be asking. The Humphrey Hawkins Full Employment Act, which governs the Fed's operation, requires the Fed to pursue price stability and full employment, which is defined as 4% unemployment. It would be hard to maintain that current policy is consistent with these goals.

At this point the Fed is explicitly discussing its plans for an exit strategy, moving away from its policy of quantitative easing. This means we should anticipate a general upward movement in interest rates in coming months, although the speed of this movement is not clear.

This is troubling because the economy is expected to remain very weak by almost everyone, including the Fed itself. The Congressional Budget Office projects that the unemployment rate will average near 10% in 2010, 9% in 2009, and 8% in 2012. Unemployment is not projected to fall to 5% until 2015. If the Fed is retreating from its quantitative easing and allowing interest rates to rise, its policy will be doing little to push down the unemployment rate more quickly.

Meanwhile, there is little obvious basis for concern about inflation. The latest data show that the core inflation rate is continuing to decline from already low levels. There is some upward pressure on inflation from higher prices for commodities and other imports. However, this price pressure is more than offset by downward pressure on rents from a glutted housing market and other areas of oversupply in a badly depressed economy. The general direction of inflation in the next few years is more likely to be downward than upward.

If there is no basis for concern about inflation getting out of control, then there is little reason that the Fed should not be moving more aggressively to boost employment. Instead of ending its policy of quantitative easing, it should be expanding it. Its purchase programme for mortgage-backed securities is supposed to end next month. It should be instead extend and increase the size of this programme, thereby putting downward pressure on long-term interest rates. It should also switch its focus to purchases of Treasury bonds, which would lower long-term interest rates more generally, rather than just targeting lower rates in the mortgage market.

The Fed could also explicitly target a moderate rate of inflation in the range of 3-4%. The commitment would be to buy as many Treasury bonds as necessary to reach this target. This would have the effect of lowering the real interest rate, if this commitment was credible. Individuals and firms would be more comfortable borrowing, knowing that they can pay back their loans in dollars that are worth less than the ones they borrowed. This is exactly what is needed in the current economic situation.

A moderate rate of inflation would also erode the value of debt, helping to improve the balance sheet of tens of millions of households, especially underwater homeowners. This would be a big step toward getting the economy back on a normal footing.

Unfortunately, more quantitative easing or the targeting of a higher inflation rate do not appear to be on the Fed's agenda. Its sole concern appears to be ensuring that inflation does not begin to accelerate. This is not only perverse given the fact that inflation is slowing and is expected by nearly everyone to continue to slow for the next several months, it also would appear to violate the law governing the Fed's conduct.

The Fed does not have the option to ignore the full employment part of its mandate, as it appears to be doing at present. Congress should carefully question the Federal Reserve Board chairman, Ben Bernanke, when he gives his semi-annual Humphrey-Hawkins testimony this week. He should be forced to explain how doing nothing to counteract the five years of high unemployment projected by the Fed and others is consistent with its mandate to promote full employment.

Bernanke of all people should have an especially hard time explaining this path. The mistakes of Bernanke, along with Alan Greenspan, in allowing the housing bubble grow to dangerous levels are the main reason that the country is stuck is suffering from high unemployment. Millions of people are out of work not because they lack the skills or willingness to work hard. They are out of work because Ben Bernanke messed up in managing the economy. But Ben Bernanke still has his job.