Thursday, March 24, 2011

Bernanke and challenges facing the Fed

 To read about the policy challenges facing the Fed, click on

WSJ (3-24-2011) Crises Scramble Fed's Inflation Calculus by David Wessel

or watch this interview with David Wessel (3 min)

David Wessels points out that if fears of oil price increases drive up prices (make AS shift left), the Fed will not be able to keep stimulating demand (make AD shift right) without further driving up prices.

Currently the Fed is keeping interest rates low and buying assets, and thereby pumping money into the economy. In the graph below, this policy results in a rightward shift in the aggregate demand curve from AD1 to AD2. This should move the U.S. economy from point 1 (now) to point 2 (by about 2012). If all goes as planned, the U.S. would enjoy higher output (and hence lower unemployment) with only a slight increase in prices.

Unfortunately for the Fed, oil prices increases and inflationary fears may shift the aggregate supply curve left from AS1 to AS2.  If the Fed sticks with its current policies, this decline in the AS curve would send the economy to point 3, with rising prices (i.e. inflation). To fight inflation, the Fed would be forced to stop stimulating demand; AD would stay at AD1 instead of shifting right to AD2.  The Fed would have to raise interest rates and/or stop buying assets. 

So instead of moving from point 1 to point 2, with more output (and less unemployment) and mild price increases, the U.S. could end up at point 4, with less output (and more unemployment) and price increases. The Fed's hands would be tied.  Due to higher inflation, it would not be able to maintain an expansionary monetary policy intended to increase output.

Note: I have simplified Wessel's analysis by  ignoring the possibility that AD could shift left from AD1 due to reduced consumer demand. This would reduce output even further.

Watch Ben Bernanke testify before House Budget Committee,  2-9-2011 (4.5 minutes)

Bernanke points out that countries can run into trouble when the ratio of public debt to GDP reaches 100% - and that it would be ideal if the U.S. started addressing its long term problems now. He also cautions against drastic cuts right now as that will slow the recovery.

Bernanke also discusses: (1) continued expectations of low inflation for the next few years,  (2) while the Fed's primary objective is stimulating the economy, its efforts have brought in substantial revenue to the Treasury, 125 billion in last 2 years, (3) once the economy recovers, any losses at the Fed should be more than covered by extra tax revenue (due to booming economy) so the Fed will not become a drain on the Federal budget. 

When asked, Bernanke also gives an estimate of the number of jobs saved by the Fed's stimulus actions. He says a credible study by Federal Reserve economists found the Fed saved up to 3 million jobs. To watch more of Bernanke's testimony (1 hour 35 minutes) click on

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