Fed should focus on inflation, not jobs

April 5, 2011, 1:00 PM UTC

Ben Bernanke and the Federal Reserve have the authority to curb unemployment. Here’s why they shouldn’t.

FORTUNE — “No one can serve two masters.” So says Jesus in the Bible. And so say a growing number of critics concerned that the Federal Reserve is being stretched thin by the two mandates with which it is charged.

Some central banks, like the European Central Bank, have just one mandate: Keep prices stable. But the Fed has two primary responsibilities: to keep prices stable, and to make sure the nation runs at maximum employment. Our plan sounds better, in theory. After all, who doesn’t want to live in a society where everyone has a job and where the prices you pay for things like food, gas, and medicine never go up? But the actions required to meet those two mandates can be contradictory, and some observers worry we are nearing one of those inflection points today. Their big concern is that by choosing to focus on the still unacceptably high unemployment level in America, the Fed will lose sight of the mandate to fight inflation — with disastrous results.

“The whole thing can backfire,” says John Taylor, an economics professor at Stanford University and an expert on monetary policy. “Inflation starts to run up, you have to stomp on the brakes, then unemployment rises.”

The worst-case scenario? Think back to the 1970s and early 1980s, when inflation skyrocketed, unemployment followed, and the Fed under chairman Paul Volcker had to boost the Federal funds rate as high as 20% to get the situation back under control. Imagine trying to borrow money to buy a house, send a child to college, or start a business with interest rates sitting at 20% or higher, and you begin to get the picture.

What the Fed took away from those difficult years is the fundamental knowledge that — dual mandate or not — the goal of low unemployment had to take a backseat to the goal of fighting inflation. Price stability was understood to be the most important job of the central bank, with the belief that all other aspects of a strong economy would flow from that. And that’s how the Fed operated, not only through Volcker’s time but also through the 18-plus years that Alan Greenspan served as chairman of the Federal Reserve.

It’s a prioritization that Greenspan believes in to this day. “A necessary condition for long-term unemployment is low inflation,” Greenspan said recently on Squawk Box. “If the Fed does its job and stabilizes the inflation rate, that’s the maximum that the central bank can do.”

But now even sitting Fed officials worry that this once-unassailable directive could be forgotten. “This crisis has been so large, and it’s taking such a long time to come out of this recession,” frets James Bullard, the president of the St. Louis Federal Reserve Bank, “that it’s upset some of the consensus that was formed in the ’80s, ’90s, and 2000s.”

Think that’s an overreaction? Maybe. But Dan Thornton, a researcher at the St. Louis Fed, found a subtle but concerning trend analyzing policy statements from the Fed’s Open Market Committee, which sets monetary policy for the nation. He looked at statements all the way back to 1979, and found no reference to the objective of maximum employment anywhere — until Sept. 21, 2010. That happens to coincide with the Fed’s efforts to bolster its quantitative easing program, which critics assail as contrary to the Fed’s inflation-fighting mission.

Current Fed chairman Ben Bernanke has said he’s 100% certain that he will know when the Fed needs to raise rates to fight inflation. And the Fed most certainly has run all kinds of scenarios for when and how to react to a changing economy, which is fine if the economy follows a textbook recovery. But what if other factors outside the Fed’s control conspire to jack prices up even faster? Take oil prices, which soared recently as unrest set in across the Middle East. I’m betting Muammar Qaddafi wasn’t on Bernanke’s mind a few months ago. And neither was Japan.

I’m not suggesting the U.S. should rewrite the Federal Reserve’s charter — and I certainly don’t think the government should ignore the high jobless rate. But in these volatile times I’d feel a whole lot better if Fed officials focused on following just one master.

Also from Fortune:

Dear Mr. Bernanke, Press conferences are a bad idea

It’s time to end the party of easy money

Fed testing inflation-busting tool

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