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Monday, November 22, 2010

NY Times: Odd corollary to the Volcker Fed?

by Calculated Risk on 11/22/2010 09:38:00 PM

From Sewell Chan at the NY Times: Fed Adopts Washington Tactics to Combat Critics

Faced with unusually sharp ideological attacks after its latest bid to stimulate the economy, the Federal Reserve now faces a challenge far removed from the conduct of monetary policy: how to defend itself in a hyperpartisan environment without becoming overtly political.
The situation forms an odd corollary to the early 1980s, when ... Paul A. Volcker, sharply raised interest rates, setting off back-to-back recessions in a painful but effective war on inflation.

Liberals attacked Mr. Volcker, a Democrat, as an inflation-fighting zealot who disregarded the plight of the unemployed. Now conservatives are portraying Mr. Bernanke, a Republican, as trying too hard to stimulate growth and underestimating the risk of inflation.
Unemployment and Inflation Click on graph for larger image in new window.

When Paul Volcker became Fed Chairman in August 1979, inflation was close to 10% (year-over-year change in core CPI). The unemployment rate was close to 6%. As the Fed tightened (taking the Fed funds rate to around 20%), the unemployment rate started to rise sharply.

So there were two problems in the early '80s: very high inflation, and a rising unemployment rate. It is understandable there was friction between the dual mandates of the Fed - especially when inflation started to fall and the unemployment rate was in double digits.

Now the unemployment rate is at 9.6% - a real and painful problem. And inflation is low and falling. So what is the source of the friction today? The risk of future inflation? This "odd corollary" doesn't work.