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A simple problem – let’s say the central bank has a 2% inflation ceiling. Ergo, if it records inflation expectations as over 2%, it will take action to lower those expectations, usually raising interest rates as a way of draining the money supply, which also has the effect of decreasing total economic activity. Additionally, everyone knows this, so when some activities or events occur that would ceteris paribus increase inflation expectations markets presume the central bank will act to quash inflation and therefore adjust their overall expectations of economic activity. This will probably manifest itself as a reluctance to invest.

Let’s say unemployment is 10%, inflation is 1%, and real GDP growth is 1%. Let’s further say that the central bank is willing to tolerate an unlimited amount of RGDP growth but refuses to budget on its inflation ceiling. Let’s further say that any activation of idle labor will necessitate some inflation due to short-to-medium-run supply inelasticities. And let’s say everyone knows all of this.

Let’s say some large positive exogenous shock causes a boom in labor demand in some sector or another. This model would predict a largely zero-sum net gain in employment or economic growth, as the increase in activity in that sector will be offset by a decline elsewhere. The only net increase would be that commensurate with accommodating short-to-medium run supply inelasticities – that is, there can be some net gain every period, but only enough that it doesn’t push up prices very much.

Consequently, the Committee anticipates that the unemployment rate will decline only slowly toward levels that it judges to be consistent with its dual mandate.

Forget the policy; regarding the politics of Operation Twist, here’s an interesting take from Jonathan Bernstein over at Greg’s place:

What I think the key is to understanding the leaders’ action is to remember at all times the precarious situation McConnell and, especially, Boehner find themselves in: They just aren’t Tea Party true believers, and everyone knows it — which means they are constantly only one step ahead of being labeled RINOs and drummed out of their positions. Not only that, but they constantly find themselves in the unfortunate position of having to agree to pass things — appropriations, the debt-limit increase — that will be signed by the Kenyan socialist in the White House. So, from their point of view, any rhetoric that will play to the crazies while not imposing actual legislative obligations on them is a pure win. Fed-bashing, from this perspective, is a natural fit.

And via zerohedge here’s some wisdom from Michael Feroli of JP Morgan:

Another question is how the political pressure will affect potential dissenters. In the absence of this letter we would expect up to three hawkish dissents once again — provided the Fed takes some action — and possibly one dovish dissent from Evans. However, the letter from the Congressional leaders cited in support of its view "significant concern expressed by Federal Reserve Board Members," among others. (Presumably the letter meant FOMC members, as Federal Reserve Board members have been generally supportive of Bernanke’s policy). There is a chance that Committee members who have some reservations about Fed policy may now be less likely to dissent, to avoid validating the views expressed in the Congressional letter, as surely all on the FOMC — hawk or dove — would find this political meddling repugnant. It’s probably still the case that we get another handful of hawkish dissents, though there is now a chance the Committee circles the wagons in response to the political pressure and we get fewer than three dissents.

This, I think, is fascinating. If both of these guys are generally right, then the GOP leaders played to their base but managed to piss off the Fed enough to guarantee that the Fed would enact (in theory) more stimulative policy. This of course only dampens GOP chances of winning the White House next year. So the reactionary extremist base that has captured the GOP is creating such a toxic dynamic within the party that it can’t even pursue its own interests in the simplest fashion.

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