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A Divided Fed . . . So What?

08/31/2011

To understand the Fed, one has to understand their “dual mandate.”  They are charged with minimizing both inflation AND unemployment.  What could be wrong with that?

This dual mandate came about when Keynesian economics was the dominant school of thought.  One Keynesian principle is something called the “Phillips Curve,” which looks like this:
You can see that the inflation rate falls as the unemployment rate goes up and vice versa.  In other words, there is a tradeoff between two evils.  Congress, in its wisdom, gave the Fed the responsibility to navigate between these evils.
So far this year, we’ve seen inflation rise with no drop in unemployment.  The Keynesian response is that it takes time to turn an aircraft carrier.  The Supply-Side response is to cut taxes on the “job creators” who will then bring the unemployment rate down.  The Austrian response is to balance the budget and these evils will fix themselves.
That is all fine and good but is not helpful to the Fed, who is actually saddled with the responsibility of managing both evils.  Is it any wonder that there is disagreement inside the Fed over how to handle the dual tasks?
Yesterday, the Fed released the minutes of their last meeting three weeks ago.  It showed honest disagreement in a complex environment with conflicting data.  Now de-sensitized to the cost of gridlock, Wall Street was not frightened by this dissension.  Instead, it saw that some members of the board are still arguing for QE3, which is expected to be as good for Wall Street as QE2 was.  The Dow took heart and closed up 20 points.  Surprise, surprise . . .

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