Why the Fed will repeat its worst error

June 6, 2011, 2:36 PM UTC

Is the Fed doomed to repeat its most infamous mistake, the 1937 monetary tightening that extended the Great Depression?

The answer is no if you take the Fed’s word for it – though it’s hard to feel reassured if you happened to keep an eye on one top official over the past year. Recent hawkish comments by St. Louis Fed President James Bullard show the temptation to talk a big game on inflation, whatever the cost.

Don't try this at home

A recent Fed paper concludes, not exactly surprisingly, that the central bank won’t make the same mistakes again. New York Fed economist Gauti Eggertsson contends that while the Fed of the 1930s was apt to overreact to commodity price shocks, nowadays we know how to take the occasional commodity price surge with the appropriate grain of salt.

And what makes us so smart? Eggertsson argues that the key advance over the past 70-plus years is that economists now tend to look beyond jumpy headline inflation numbers to so-called core inflation, which excludes food and energy prices. A glance at core inflation in 1937 would have shown nervous central bankers that the inflation surge they thought they were clamping off was in fact largely a supply shock confined to a few key goods such as corn and copper.

“A modern economist most likely would have identified the price rise in 1936 and 1937 as a temporary upswing in commodity prices that did not signal a significant increase in overall inflation,” Eggertsson writes.

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Yet some economists nowadays clearly are less modern than Eggertsson imagines. Take Bullard, the president of the Federal Reserve Bank of St. Louis. Last month he published a paper calling core inflation “a rotten concept” and urging the Fed to stop paying attention to it.

“It is time to drop the emphasis on core inflation as a meaningful way to interpret the inflation process in the U.S.,” he said in a May 18 speech at New York University.

Bullard’s comments were notable because he was Ben Bernanke’s sidekick in pushing the bond-buying program known as quantitative easing that the Fed adopted late last year. Back then Bullard was an enthusiastic follower of core inflation, judging by a widely cited August presentation that used the phrase not once or twice but seven times.

Why the about-face? Perhaps Bullard wants to show the Fed knows people can’t eat iPads for dinner. In an interview, Bullard says he believes the Fed risks losing credibility with the public by ignoring the prices of goods that account for a substantial share of household spending.

“It’s damaging to the Fed to talk about core inflation when everyone can see headline inflation is rising,” Bullard said last month. “We need to talk about our challenge in terms of headline inflation, not restate it in terms of something else.”

Yet as stirring a soundbite as that makes, it is a dangerous bit of grandstanding to be linking policy to the more volatile series (see chart, bottom right) at a time when unemployment is 9.1% and, seemingly, not coming down much any time soon. Yes, food and energy prices are higher, but is that necessarily something tighter money is going to fix? And if so at what cost?

As the Eggertsson paper notes, the Fed’s fearful tightening in 1937 halted a recovery that had taken years to develop and dealt sharp blows to employment and production (see chart, above right). A premature response to the next energy shock could surely do the same to the current economic upturn, as shallow as it now appears.

What’s more, for all its bubble-era laxity the Fed has erred on the side of being too tight more recently than 1937. David Beckworth, who teaches economics at Texas State and writes on Fed policy at his Macro and Other Market Musings blog, points to the Federal Open Market Committee meeting that took place Sept. 16, 2008 – the day after the failure of Lehman Brothers and the day the Fed was preparing to make an $85 billion loan to AIG (AIG).

Which line should you follow?

Though all measures of inflation were coming down as summer turned to fall and the economy clearly was slowing following a July brush with $4-a-gallon gasoline, the FOMC decided to hold the fed funds rate at 2%, concluding that “the downside risks to growth and the upside risks to inflation are both of significant concern to the committee.”

As it turned out, the upside risks to inflation didn’t materialize. To the contrary, the Lehman Brothers bankruptcy and the collapse of the shadow banking system exposed the economy to a severe credit shock.

Real interest rates, which subtract inflation from the nominal rate to show the true cost of borrowing, soared as high as 8% in the aftermath, as demand for goods and services evaporated and prices tumbled.

All this because the arm-waving following the summer’s run to $147-a-barrel crude — which briefly pushed the headline consumer price index above 5% — scared the Fed into wanting to look tough on inflation. Sound familiar?

“Effectively they ended up tightening during the crisis – and it was because they were afraid of looking soft on inflation,” says Beckworth. “They were lulled by the siren of headline inflation.”

Bullard insists that tracking headline inflation rather than core doesn’t force the Fed into anything. In mid-2008, he said, the Fed could have stayed on the sideline even with inflation above 5% “by laying out a clear explanation for why headline inflation is high and why you aren’t taking immediate action.” Doing so, he says, “would free you up to do other things,” such as explain what sort of events might lead to policy responses.

In any case, Eggertsson says the Fed won’t be lulled again the next time. But watching Bullard play to the hawkish crowd, it’s hard to share the researcher’s optimism.