Bloomberg has a rather nice piece today about a fight between economists at the two most prominent investment banks: Goldman Sachs and Morgan Stanley. Morgan worries about the Fed's ability to tighten monetary policy and control inflation. Goldman doesn't. Who's right? I'm gonna have to side with Morgan Stanley on this one.
Here's the gist of the argument, from Bloomberg:
Joachim Fels, co-chief global economist at Morgan Stanley, sees a risk that the Fed will keep the easiest credit since the Great Depression for too long. Ed McKelvey, U.S. economist at Goldman in New York, says those concerns are overblown, and that officials have time to deploy as many as 10 options for ending their $1.1 trillion aid to the banking system and economy without letting consumer prices climb.
Goldman is correct that the Fed can control inflation. But saying they can control inflation is different from saying they will control inflation. I find Goldman's view a little naïve, because politics aren't being factored in. There are a few good tidbits from the Bloomberg article that explain. The first is by Allan Meltzer, a Fed historian and economics professor at Carnegie Mellon University in Pittsburgh:
"The Fed absolutely has the tools and know-how, but the question is, will they have the guts to use them? I don't think there is a snowball's chance in hell they will be willing to tighten to slow inflation down."
The article also says that Martin Feldstein, a professor of economics at Harvard University, agrees:
"I don't worry about the technical ability of the Fed to do it."
"What worries me is the political hurdle that they would be facing." Congress won't "easily" digest the Fed's desire to limit lending and restrict inflation, Feldstein said.
This all boils down to timing. Will Washington be able to stomach the Fed tightening the monetary supply early enough to control inflation? Let's think about that timeline.
Can the Fed begin to tighten in 2009? Since unemployment will likely continue to increase to or hover at double digits through the end of the year, I find that doubtful. Until unemployment is clearly getting better, Washington won't allow the Fed to tighten.
What about 2010? In February, Bernanke's term is up. After that time, Obama can decide if he wants to replace him. He probably will do so, and that replacement will probably be the President's favorite economic guru Larry Summers.
With one of his own advisors as Fed chief, that will make it even harder for the Fed to resist Washington's political pressure. So imagine it's early to mid 2010. Midterm elections season is in full swing. Can you really see Congress and the President allowing Summers to tighten monetary supply and risk an economic recovery just in time for voters to head to the polls? I know I can't.
That leads me to believe that the Fed will be under serious political pressure to keep money supply loose until at least early 2011 -- after the elections. I think with a new Obama-selected Fed chief in there starting in 2010, that political pressure becomes even more relevant.
Will 2011 be soon enough? Tme will tell, but if the economy starts improving in early 2010, I worry that may be too late to prevent a greater rate inflation than what we've seen in several decades.