What would you do as part of the Fed?

Question

Suppose the economy is experiencing an adverse supply shock given by the increase in the oil price. , we should expect that the SRAS curve will be shifted upward and price will increase even in the short run - or basically having inflation in the economy

If you are the chairman of the Federal Reserve, what are you going to do about it?

What kind of monetary policy do you think the Fed has imposed recently? Please justify your opinions by facts or/and theories.

Please help with this question. Really confused as to what I would do if I were part of the fed....

Answer 1

It all depends on the state of the economy.  The Fed has a dual mandate: To maintain price stability and ensure maximum employment.  

Regarding your question, the Fed generally ignores headline inflation and instead focuses on core inflation which omits the prices of commodities such as food and oil due to their inherent volatility.  Historical data proves the Fed right, however, there is much reason to believe that current shocks in oil and food prices may leave the prices of these commodities permanently elevated, albeit at lower price levels than they are currently.

Generally, to combat inflation, the Fed would have to raise interest rates and contract the money supply.  However, as mentioned earlier, the Fed has another mandate, and that is to ensure maximum employment; in simpler terms, maintain a healthy, sustainable growth rate.  The recent subprime and housing crisis has diffused to and has affected virtually every aspect of the U.S. economy.  It is perhaps the primary reason many believe the U.S. is bound for a recession.  The Fed has kept interest rates low and liquidity flowing to ensure that the financial markets operate properly allowing businesses and consumers to retain flows of credit; in other words, the Fed has acted to keep the U.S. economy from seizing up like an engine running without oil.  

Right now the chairman of the Fed, Bernanke, faces a difficult decision.  Some might say that the U.S. is currently facing a stagflationary dilema, where inflation and poor economic growth occur simultaneously.  In that case raising interest rates will help growth, but spur further inflation.  Tightening rates will fight inflation, but could be disastrous for growth.  

Essentially the Fed has to determine which threat to the well-being of the U.S. economy is more important.  

Due to the credit crisis, I feel that the Fed was right in loosening rates and increasing liquidity.  Clearly the threat of collapse and chaos in the financial market has posed a greater threat to the economy than inflation in the past few months.  However, I believe the Fed has done enough.  Considering there is a span of several months before any Fed action has time to actually effect the economy, I believe we will see the positive effects of the Fed's loose monetary policy sometime this summer.  The Fed should now focus its efforts on inflation as high commidity prices seem to now be affecting items counted in core inflation, otherwise it may lose its credibility and that could quite possibly be the worst possible shock to the U.S. economy.