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What Should the Fed Do When Its Goals Are in Conflict?

We know that the goals of the Fed include price and output stability. Sometimes these goals conflict, and when they do, the task of central bankers becomes even more complicated. The FOMC statement with which we opened this chapter stated that the “Committee perceives the upside and downside risks to the attainment of both sustainable growth and price stability for the next few quarters to be roughly equal.” But what if instead it had said the “Committee perceives the risks of low output growth and high inflation for the next few quarters to be roughly equal”? What would the appropriate monetary policy be in this case? Should the Fed use its power to stabilize prices or to promote economic activity? The tension is evident from the Taylor rule. Here is an example: the target real interest rate increases when inflation is high and decreases when the output gap is high: real interest rate = −(1/2) × (output gap) + (1/2) × (inflation rate − 4 percent). Remember that a positive output gap means that that the economy is in a recession: actual GDP is below potential. When the economy is in recession and inflation is not very high, the Taylor rule says that the Fed should reduce the real interest rate. And—from this same rule— the Fed should increase the real interest rate in the face of high inflation and a negative output gap. But what should the Fed do when inflation is high and there is a recession? High inflation argues for increasing real interest rates, but a positive output gap argues for a cut in rates. The Fed—and, indeed, monetary authorities throughout the world—faced exactly this conflict in the mid-1970s when oil prices increased substantially as a result of actions by the Organization of Petroleum Exporting Countries. Researchers who have examined data over the past three decades have found that an increase in oil prices is typically met with an increase in the federal funds rate. [3] Thus, when faced with conflicting goals stemming from an oil price increase, the Fed seems to have put more weight on the goal of price stability. When Things Go Badly Wrong Everything that we have talked about in this section helps to explain why central bankers must be skilled and knowledgeable individuals with a good grasp of both economics and the workings of financial markets. Still, we have essentially been describing the job of a technocrat. Central bankers really earn their salaries in abnormal rather than normal times. Starting in 2007 and stretching well into 2008, the United States and other countries began to experience financial crises that were similar in some ways to those experienced in the Great Depression. [4] The crisis seemed to begin innocently enough, with a decrease in housing prices that left some people unable or unwilling to cover their mortgage payments. But because of the way financial markets work, it became very hard for lenders to work out which of their assets were “nonperforming”—that is, unlikely to be repaid. As a result, financial markets froze up.

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