FT Endorses Fed Policy So Far

June 2, 2008

The lead editorial in today’s Financial Times gives the FOMC reasonably high marks for setting the correct priorities since the outbreak of the credit crunch ten months ago. As noted, policymaking is most sensitive to limiting “tail risk” rather than pitching simply to the most likely economic scenario. At the height of the period of misfiring financial markets, the potential harm if the Fed provided too little stimulus was far higher than what might have happened if the Fed had cut rates more aggressively than was required. So officials correctly erred on the side of too much stimulus.

Now, the FT observes, two negative growth risks persist — the imploding housing market and higher oil prices — but financial markets are at less risk than before. On the other hand, inflation looms now as a much clearer and more present danger than back in January when the Fed was easing most aggressively. Oil is the main culprit. Fortunately, as the FT points out, U.S. unit labor costs remain well enough behaved for the Fed not to respond immediately to upwardly creeping expected inflation. But if expected inflation continues to trend higher and if commodity prices keep grinding upward, the Fed ought to raise rates even if growth is still lackluster. A shifting balance in the “tail risks” between the ramifications of eroded price stability and deficient economic growth demands no less. I agree with the Financial Times. The cost of reestablishing Fed credibility after the inflationary 1970’s and 1980’s was too great and took too long to take a chance of having to wage that battle all over again. At the same time, there are other, more directed tools than broad monetary policy that officials can use to safeguard against a financial market meltdown.

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