Is the Fed more concerned with inflation than with unemployment?

Yes, according to Dean Baker. The point of departure for his most recent article (published at Z Net and truthout.org, but curiously not at his blog Beat The Press), is what was probably intended to be a throw-away line from an investment analyst in a Washington Post article. According to the analyst, “The Fed chairman may be appointed by the president and confirmed by the Senate, but his real bosses are on Wall Street.” Whereas Baker sees this as a searing indictment of our current political system, I am a not really all that surprised (although equally dismayed). For more background on how the Fed operates and to understand the incredible amount of power it wields, I highly recommend William Greider’s book Secrets of the Temple, an 800-page analysis of the Fed under the guidance of Paul Volcker from 1979 to 1987.

Baker, an economist at the Center for Economic Policy Research makes the point that Wall Street doesn’t like inflation because it lowers profits, and therefore there is tremendous political pressure put on the Fed to raise interest rates, which restrains inflation. The downside, however, is that raising interest rates makes it more expensive for people to borrow money, slows down the economy and lowers unemployment. This increase in unemployment also puts downward pressure on workers’ wages. Thus, according to Baker, “[B]y using unemployment to slow wage growth, the Fed can restrain inflation.”

In conclusion, “It is important to understand these facts when we hear it asserted (correctly) that the Fed answers to Wall Street. The most disadvantaged people in society are the ones who suffer when the Federal Reserve Board decides to clamp down on inflation.”

I’m a big fan of CEPR and of Baker’s work, but I am a little confused by his thesis. I have no problem accepting his argument that the Fed answers to Wall Street (although pointing out one analyst’s statement to that effect in the Washington Post doesn’t in itself prove it is necessarily so), but wouldn’t raising interest rates to fight inflation also hurt profits at Fortune 500 companies by making it more expensive for businesses to borrow and invest capital? For example, Wall Street (or at least the stick market) reacted with disppointment in May when the Fed raised interest rates, with stocks widening their losses after the mid-afternoon announcement was made. Also, Inflation erodes the wealth of everyone, including Middle Class Americans and it is wholly appropriate for the Fed to be concerned with holding it in check. If raising interest rates is not the best way to combat inflation, what is a better policy?

Greenspan lowered interest rates dramatically in response to the recession of 2000-2001, which has led us to the point that we are now righfully concerned about inflation. In essence, lowering rates replaced the dot-com bubble with a housing bubble, which has led to residential housing prices being 55% higher in 2005 than they were in 2000. Although lowering rates may have been good as far as employment and wages, as Baker argues, by raising housing values it has led to a host of other economic problems, including allowing many consumers to borrow and consume far beyond their means due to the “household debt bubble”.

So was Greenspan ignoring the wishes of Wall Street in aggressively slashing interest rates in 2000? I don’t have a Ph.D in economics, but I suspect the reality is more complicated than the short editorial would lead one to believe. Maybe right now Bernacke is more concerned with the threat of inflation than with slowing down the economy, but does that mean that by default, the Fed is always biased toward keeping interest rates high? To be clear, I don’t necessarily agree that inflation is the biggest threat to the economy (Robert Reich makes, I think, a fairly compelling case that stagflation is a bigger challenge than inflation), but I’m not sure if this necessarily proves Baker’s thesis.