Opinion and Economic Analysis

HICKS: Monetary policy for our times may involve trade-offs

December 10, 2011

It has been some time since I have written about monetary policy. The waves of fiscal stimulus—spending and tax cuts—have dominated the debate almost since the stock market crisis of 2008.

But this week, Charles Evans, president of the Federal Reserve Bank of Chicago and leading contender to replace Ben Bernanke as Fed chairman, visited Muncie to give an important speech on moving the economy past the recession. That prompted me to write about the Fed’s role and attempt to explain how it might change.

I should note that a threat to disrupt the speech from the Muncie chapter of the Occupy Wall Street crowd slightly tarnished the day. It increased the cost of providing security to an event and led to the cancellation of a meeting between Evans and students. This was unfortunate. One wag noted that all the security was unnecessary when simply posting a “help wanted” sign would have been enough to keep protesters at bay. This is unfair, of course, but I suggest it is time for Occupy folks to come up with workable ideas of their own instead of merely impeding others from sharing theirs.

Monetary policy—the setting of interest rates and money supply—was the focus of Evans’ speech. In it, he argued for a policy change that would find the middle ground between two divergent explanations for what is causing the lingering pain to the U.S. economy.

At one extreme is the idea that a slow recovery is the inevitable outcome of a mismatch between the skills jobless workers possess and ones employers need. This is termed a structural problem. If true, the unemployment rate will remain high for a long time, regardless of policy changes. Efforts by the Fed to stimulate employment would simply lead to inflation. An opposing explanation is that the economy is in a “liquidity trap,” in which borrowing and lending are constrained by dismal expectations of the future.

It is a measure of the poverty of our political discourse that these are often labeled the conservative and liberal diagnoses of our problem.

Evans proposed a policy that is a trade-off between the unpleasantness of continued high unemployment and higher inflation. He argues that if we risk a tad bit higher inflation (3 percent instead of the current 2-percent target) anytime the unemployment rate is above 7 percent, we might push the economy toward what he terms “escape velocity” where the private sector begins to grow.

A year ago, I would have labeled this risky. Since then, the burst of high energy prices—which often results in inflation—did nothing of the sort. Inflation remains at bay, while high unemployment is sadly here.

This week in Muncie, Evans amplified his proposal to accept the risk of higher inflation to potentially cure high unemployment. It is a beguiling notion that warrants serious consideration as one of the least painful ways to escape the recession.•

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Hicks is director of the Center for Business and Economic Research at Ball State University. His column appears weekly. He can be reached at cber@bsu.edu.

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