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What's the Fed to Do?

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Why the debate over who should be the next Federal Reserve Chairman? There is a tug of war going on between inflation 'doves' and 'hawks' within the Fed. The debate is whether inflation is or will be a problem because of the $3 trillion plus in money the Fed has injected into the economy, which means will QE3 end sooner or later and in turn when interest rates should be allowed to rise.

And that debate really has little to do with who will succeed Fed Chairman Bernanke next year. Both Vice-Chairman Janet Yellen and Harvard economist Larry Summers are basically doves who advocate the Fed's purchase of securities to support low interest rates until the economy recovers.

Though Larry Summers' sojourn as president of Harvard was a disaster with his seeming lack of administrative abilities, and derogatory remarks against women faculty members. Whereas Dr. Yellen has been groomed to become the first female Federal Reserve Chairperson with her many years serving on the Fed's Board of Governors.

In fact, even the debate between budget doves and hawks is artificial. The problem is that interest rates (and budget deficits) are driven by many factors, including the cost of money. And the demand (and cost) of money only goes up (while budget deficits decline) when there is a growing economy. This is not the case today, when first quarter GDP grew just 1 percent, while Q2 GDP was barely higher at a 1.7 percent growth rate. This is uncomfortably close to recession levels, even though Bernanke's Fed has continued to buy $85 billion per month in securities.

So there is little demand for money's use at present, as mirrored by consumer loans, for instance. Even with record low interest rates, helped by the Fed's bond purchases, consumers can only borrow so much when their incomes haven't even risen as fast as inflation since 2000.

Chairman Bernanke explained it best in his latest congressional Q&A, as we said last week. "There's a distinction between prices being high and prices rising... (cost of living) isn't going up, it's high, it's not going up. In other words, real wages are going down because even though inflation is very low wages have been growing slower than inflation."

2013-08-06-inflation.jpg

Graph: Econoday

So what is the Federal Reserve to do with household incomes still on the decline, and no inflation? Keeping interest rates as low as possible serves two purposes. It makes credit cheaper and keeps prices lower for consumers. It also makes investing in new plants and equipment cheaper, which encourages more investment in plant expansion and hiring.

Unfortunately, the other branches of government are locked in paralysis, with Republicans only interested in programs that reduce household income, rather than increasing it, by blocking employees' collective bargaining in Republican-held states and food stamps for needy families. This has a direct effect on consumers' real disposable incomes, which in turn reduces the very demand for goods and services that would encourage economic growth.

So the fears of asset bubbles and runaway inflation are really distractions at the present. Small government conservatives use the fear of inflation as a camouflage from their real agenda of smaller government. Conservative economists don't like debt, period, in the belief government borrowing will crowd out private debt. But that can only happen with fuller employment and booming growth.

The real debate is how much power should the Federal Reserve wield, if any. And that is not a debate we should be having at present. With no one else providing aid to this recovering economy, the Fed is all we have at present to prevent inflation declining further, and another recession.

Harlan Green © 2013