The Punch Bowl

The great Fed Chairman Bill Martin was quoted as saying his job was to “take away the punch bowl, just as the party is getting good.” [1] What he was referring to is that the Fed has to predict when to react to mounting inflationary pressures and take those measures before the long-term trends can be established. The Fed has to balance the short-term business needs for growth and low-cost access to capital, and the public needs for employment opportunities, against the long-term effects of low interest rates that could cause overinvestment and overstimulation of the economy and long-term damage in terms of inflation.

If the current Fed chair, Janet Yellen, does not “take away the punch bowl” soon, then we will certainly be on our way to pushing the inflation pendulum to the other side, toward inflation. The effects of inflation on the business cycle are twofold: Inflation puts pressure on producers to consider price increases in their products and, if prices get too high, it can cause consumers to cut back on spending, leading to a slowdown in consumption and eventually a recession.

It appears as though there are two modes of thought within the Fed. One perspective, led by current Fed Chair Janet Yellen, is that the Fed needs to continue gradual increases to the Federal Funds rate (the interest rate that banks pay the government for loans). Another perspective, led the St. Louis Fed President James Bullard, is that current inflationary pressures are minimal, and that the Phillips curve principle (that inflation and unemployment are inversely related) no longer applies. We will soon see which opinion will carry the day... and if Yellen receives a second term...

[1] The Fed: The Inside Story of How the World’s Most Powerful Financial Institution Drives the Markets, by Martin Mayer, 2001, The Free Press (A Division of Simon & Schuster, Inc.), New York, New York, page 165