Stopping a Recession Or Trying To Do Too Much?

Recession. Inflation. What's a Federal Reserve Board Chairman to do? Last week, in testimony before the House Financial Services Committee, Federal Reserve Board Chairman Ben Bernanke said that inflation is the lesser worry and preventing a recession is what he needs to focus on.

The problem is this: Inflation is already starting to heat up. It is up over 4% in the twelve months to January. That's a lot. Generally, prices go up, i.e., inflation occurs, when there is more money in the economy chasing the same amount of goods and services – or when the increase in the amount of money is more than the increase in the amount of goods and services. One way to increase the amount of money in the economy, i.e., to increase the money supply, is for the Federal Reserve Board to lower those short term interest rates over which it has control. (A way for the Fed to slow down the increase in the money supply is for it to increase interest rates.)

The difficulty for the Fed is that the way it can try to push the economy along a little faster is also to lower interest rates. Therefore, the Fed has to be careful that, when it is lowering interest rates to help the economy, it doesn’t lower them so much that it ignites inflation. What makes this even trickier is that it takes a while for the effects of an interest rate cut to be felt. It doesn't affect the economy right away. Therefore, for example, it's going to take a while before the recent interest rate cuts boost the economy. The problem is, by then, or shortly thereafter, the increase in the money supply (that came with the interest rate cuts) could very easily push inflation up higher.

Now, all of these interest rate cuts may prevent a recession, but there is a good chance they won't. As I said, it takes a while for the effects of interest rate cuts to be felt. Given the official definition of a recession (two consecutive quarters of negative economic growth), we could already be in the first part of a recession. We don't know, and we won't know for a while. It wouldn't be surprising if we were, though. After all of the "irrational exuberance" in the housing market, it wouldn't be surprising if there needed to be some readjustments in the economy, and it wouldn't be surprising if those readjustments resulted in a recession. Interest rate cuts now aren't going to do much to stop a recession if we are already in it.

But those interest rates cuts could feed inflation down the road. Which means inflation could really take off. What will the Federal Reserve do about that? Will they raise interest rates to try to cut inflation? The problem is, by the time they do that, it might be too late – again because of the delay in the effects of the Federal Reserve's actions.

What we could wind up with is the Federal Reserve going first one way then the other. Cutting interest rates to boost the economy; then raising interest rates to cut back on inflation. Each time the Fed would be acting too late, and each time it could make the problem worse in the opposite direction.

While this may sound extreme, it is not all that far off from what happened in the late 1960s and 1970s. "Fine-tuning," as it was called back in the 1960s, did not work. We got recessions, we got inflation, and eventually we got stagflation.

A recession would be unfortunate, but it does not have to be the worse thing in the world. What would be worse would be an attempt to prevent a recession that not only fails to do that but also sets off an inflation that is worse that the recession we couldn't prevent. We could wind up with a Fed running back and forth between cutting interest rates to stimulate the economy and raising interest rates to cut inflation – and achieving neither.

A government agency that tries to do too much often winds up accomplishing less than one that knows its limits and stays within them. In that way government is a lot like baseball. Try to do too much, you'll probably just strike out or pop one up to short. Stay within yourself, you might just drive that run in.