The national accounts Core PCE deflator, a measure of prices that does not fix the basket of items so rigidly, is the measure that the Fed watches most closely in setting monetary policy. From Friday’s first estimate of GDP we also have the first estimate of Core PCE inflation for 2010 quarter 1. It is now at its lowest quarter-on-quarter growth rate since 1959 at 0.6 percent. Charts of these data are included below.

It is interesting that with real consumption growth of 3.6 percent, inflation is this low. Apparently, it is the household who has the upper hand in the retail marketplace. This will likely continue for at least another quarter.

Low Core PCE inflation makes the FED’s job easier, as their expansionary monetary policy has not yet created any inflation. This is a good thing, since monetary policy challenges still remain. As the NBER admitted a couple of weeks ago, we are not necessarily out of the woods yet.

How will the Fed raise the short-term market interest rate? The old-fashioned way of tightening monetary policy is to shrink the amount of reserves outstanding by selling assets. Over the past one and a half years, the Fed has piled on securities with long maturities and exposed itself to credit risk. If it sold those assets, it would post considerable losses, deadly to the institution’s already fragile reputation in the current political climate. Instead, the Fed will raise the rate it pays on excess reserves (or deposits of banks at the Fed). Banks will pull up interest rates in the money market as the alternative use of reserves—parking them at the Fed—becomes more remunerative.

Who at the Fed will raise the short-term market interest rate? Congress explicitly gave the authority to raise the interest rate on excess reserves to the Board of Governors (or the seven appointed officials who work in Washington), not the Federal Open Market Committee (FOMC, or the board governors and a subset of reserve bank presidents who normally vote on reserve conditions). Thus, the balance of power within the Fed will shift toward the governors when the instrument of policy becomes the interest rate on reserves. (Bernanke elided this issue in his recent testimony when he left the impression that the FOMC will still set policy in conjunction with the board. In fact, the Federal Reserve Act prohibits the board from delegating monetary policy to others.) This matters because two slots on the board are currently open, giving the White House an important opportunity to shape monetary policy through future nominations. Indeed, given natural turnover among governors, President Obama will probably be able to appoint a majority of the board in a single term of office.

In the first paragraph, Vince highlights the flipside of quantitative easing. The Fed bought a bunch of long-term financial assets, the value of which will go down when interest rates go up. Now, owning these assets is a constraint on Fed actions. There is already plenty of pressure to reduce the already-compromised “Fed independence.” Selling those assets at a loss will further increase pressure for more congressional oversight.

This means the Fed will control inflationary pressure by increasing the rate they pay on excess bank deposits at the Fed. That will work, but it will likely have a more negative impact on economic activity than traditional methods. With high risk-free yields at the Fed, banks, already under regulatory pressure, undercapitalized, and risk averse after the 2008 meltdown, will have no incentive to lend. Small business, which traditionally funded growth with bank loans, will have difficulty obtaining capital. Big business, with direct access to debt and equity markets, will have easier access.

Economic growth, therefore, will probably be slower than under traditional Fed tightening, and it will be biased toward big business. Small business, handicapped by an uneven playing field, will almost surely decline as a percentage of business activity.

The second paragraph is important, because it implies that Fed policy will become more political. Given current and projected United States debts levels, political pressure to monetarize the debt will be strong. As debt levels and interest rates increase, interest costs will soar, as will the pressure to inflate. Will a more politicized Fed resist that pressure? I wouldn’t bet on it.

Jeff isn’t buying any of this. He says:

It seems peculiar to me that the Fed would conduct its monetary policy with a major constraint being the effect on its own profitability. While it might be embarrassing to sell some securities at a loss, it would be even more embarrassing to have a portfolio like the thrifts in the 1980s: long-term fixed rate assets funded with short-term liabilities in a rising rate environment. That would look really stupid.

Good point. We’ll see.

Scott Sumner maintains a blog in which he has argued that the FED should not target interest rates, but instead target nominal GDP. When the economy experiences a Liquidity Trap, as it arguably did in late 2008 and 2009, reducing the short-term target interest rate becomes ineffective as interest rates approach zero. Besides the traditional interest rate policy, in this recession the FED has also pursued a program of quantitative easing, including aggressive purchases of long-term debt securities. This new policy tool was Bernanke’s innovation, and we think it helped, especially during the second half of 2009.

While low short-term interest rates helped a bit, we believe the quantitative easing was the more effective policy tool. However, the FED could have done more. They could have targeted nominal GDP. How would they implement this policy? Obviously, they could not implement it via interest rate targeting.

They would buy things.

In this recession the best thing they could have bought would have been homes. Purchases of homes in areas hard-hit by foreclosures would have been especially helpful. Foreclosures kill a neighborhood like little else. They have and are causing continuing losses at Wall Street and at banks across the country. In turn, bank failures and weak banks are a continuing drag on the economy.

How might the Fed administer a real estate purchase program? They could use local housing authorities and agencies. The local housing authorities understand the communities they work in. They are already in existence in virtually every community, even small ones, and they know how to purchase and administer residential real estate. It is already the case that, in many areas, local area housing authorities have become the only active residential real estate developers, since the incentive for the private sector to provide new housing is very low.

Purchasing homes in hard-hit neighborhoods would restore the neighborhoods, provide a floor of support for residential real estate market activity, help with the growing demand for affordable housing, and help banks resurrect their balance sheets. It would foster a recovery.

I think Fed policy has been too tight. Instead of paying interest on excess deposit, they should be charging a fee. Of course, many disagree and worry about inflation, and that is what I thought I was reading as Shelton proceeds with her thesis that the Fed’s policy may be fueling a new asset bubble. This is pretty standard stuff, boringly standard in fact. I was about to quit reading and go on to something else when I came to a paragraph that stopped me cold:

“Deflation is seen as the bugaboo of Keynesian economics. But it can actually serve to spur economic activity as lower prices enable struggling consumers to get back in the game, and enterprising individuals can build businesses using tangible assets that yield valid profits.”

That paragraph is breathtaking, so wrong on so many levels, so counter to what we know to be true. I couldn’t believe that an economist would say that. So, I looked for her tag line. Sure enough, it says she’s an economist. I did a web search. She’s got at least one book out. She’s in the WSJ frequently. She’s all for a gold standard.

Shelton received her Ph.D. in Business Administration at the University of Utah, and she’s a professor at the Duxx Graduate School of Business at Monterrey, Mexico. One observer—goes by Federalist on the web, but I couldn’t find a name—described her as having few credentials. I don’t think that is exactly true. She has impressive credentials, just not as an economist.

Let’s correct her paragraph:

No one is going to mistake me for a Keynesian, but I’m certain that deflation is bad. Economists in general, not just Keynesian, know deflation is bad. I don’t know of one credible economist, from a top 50 school, with a Ph.D. in economics, who believes that deflation is not bad.

Shelton goes beyond saying deflation is not bad. She claims deflation is good, stimulative, spurring economic activity, “enabling struggling consumers to get back in the game.” Amazing.

Here’s the story on deflation: As prices fall, no one has an incentive to purchase anything, the cost will be less tomorrow; consumption and investment decline. Borrowers pay with deflated dollars, making real interest rates very high, again leading to less investment and consumption. Wages don’t adjust quickly, leading to unemployment, 25 percent in the depression. Asset values decline, but debts become more burdensome, leading to credit defaults and over-leveraged banks, businesses, and consumers. Lending, borrowing, consumption, investment, and economic activity decline.

One problem of smart people pontificating outside their field is that they come up with ideas that sound good, don’t hold up to serious analysis. Economists have performed a huge amount of research on inflation and deflation, empirical research and theoretical research. The profession has rejected the thesis that deflation is good. The risk is that someone with authority listens to someone like Shelton and tries to implement her recommendations. That would be tragic. Bad policy leads to a bad economy, and the costs of a bad economy are immense and not just financial. Serious recessions change lives, usually for the worse. Careers, families, and lives are destroyed. It is a shame that Shelton has a mouthpiece as big as the Wall Street Journal.

The audit idea has been around for a long time. Because of the Fed’s independence, both the wacky left and the wacky right have generated conspiracy theories around the Fed for generations. The problem is that an audit could lead to new legislation that would severely change the nature of the Fed and limit its independence. Frank and Paul, two guys with two first names, argue that they will conduct the audit in a way that does not threaten the Fed’s independence.

That is impossible. The audit itself would threaten the Fed’s independence. At the very least, it would provide days of television time for “outraged” politicians. Few audits of any organization the size of the Fed would not provide fodder for politicians bent on finding reasons to get in front of a camera. That face time could lead to some terrible policy.

The fact is that, unfortunate as it may be for congressmen and women, the Fed needs its independence to be effective. Anything that threatens the Fed’s independence is to be avoided.

The idea of limiting the Fed’s lending options is also not new. Restrictions on Fed lending practices have been more or less binding since the Fed’s inception in 1914. In emergencies, the Fed has much more leeway. One of Ben Bernanke’s real contributions has been his innovations in assets purchased and in lending. Both are part of his demonstration that the Fed is not impotent when interest rates reach zero. To try and quash these innovations in their infancy is truly amazing.

I don’t think the Fed has been perfect in its response to the challenges of the past couple of years. However, I’ve seen Congress in action over that same period. I’ll take Ben Bernanke making these critical decisions over Barney Frank and Ron Paul every time. Taking monetary policy away from the Fed and giving it to Barney Frank and Ron Paul would be stunningly stupid.