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It has been widely-publicized that Ben Bernanke, the new Federal Reserve Chairman, has strong views regarding the Federal Reserve Bank’s responsibility and ability to control inflation in the United States.

Is the Fed Wizard a Humbug?

Fed watchers jump at the Chairman’s every utterance.

Security prices zip up and down at shifting hints of future interest rate policy.

Few indeed would contend that inflation is a good thing or would say that government should adopt a laissez faire attitude to the value of money.

Arguments begin, however, when we discuss exactly how inflation might be controlled or what part of government is responsible for the task.

Short-term rates and inflation

Many seem to believe that by manipulating short-term interest rates in some precise fashion, the Federal Reserve Board should be able to keep inflation ‘under control’, without throwing the economy into recession.

However, among economists, there seems to be no consensus as to what the Federal Reserve’s magic formula should be regarding the timing and amount of short-term interest rate manipulation.

The lead story in the Wall Street Journal of July 5, 2006 reported that many leading economists fear that Chairman Bernanke has reached a ‘crossroads’ and may be about to go too far in raising rates — thereby pushing the economy into recession.

Can the Fed control inflation?

Most of the discussion about interest rates seems to start with the assumption that interest rates do indeed control inflation and that the Federal Reserve’s ability to rig short-term rates gives it the power to stabilize the value of money.

But is this assumption reasonable?

1. A significant element in the cost of living for Americans is the escalating level of sales and property taxes. However, the government does not include taxes in its calculations of the consumer price index and — in any event — the Federal Reserve has no power to cut taxes or reduce government spending.
2. Another element driving up the cost of living is the cost of petroleum and energy products, often produced outside the United States and in short supply relative to demand. Professor Bernanke does not control the price of oil or regulate the driving habits of Americans.
3. Rising medical bills — significant in the cost of living — are the result of many things that escape the reach of the Federal Reserve short-term interest rate policy, from undisciplined tort law to hospital inefficiency.

I could continue enumerating inflation factors related to government spending, inefficiency, shortage of supply, monopolistic pricing, and so forth — but the point is simply that the Federal Reserve does not have the ability or tools to operate on many — even most — parts of the economic body.

If the patient has need for heart surgery and delicate bypass instruments, we should not expect good results from a doctor who is only licensed to operate on the patient’s foot with a blow torch — even with the best of intentions.