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updated 3/21/2007 6:53:20 PM ET 2007-03-21T22:53:20
ANALYSIS

Imagine you're driving a car with a blacked-out windshield and a loose steering wheel. Now imagine that your car is the $13 trillion U.S. economy. That should give you some idea of what it feels like to be Federal Reserve Chairman Ben S. Bernanke. Yes, in a word: scary.

Bernanke and the other members of the Fed's Open Market Committee pleased the stock market Wednesday when they voted to keep the federal funds rate at 5.25 percent and slightly softened their anti-inflation stance in the accompanying statement. The new statement drops a mention of "any additional firming" of rates that had appeared in previous months' statements.

A tough call
But while it cheered Wall Street, the Fed's decision to take a gentler position on inflation wasn't an easy call at all. Under current circumstances, the natural inclination of the Fed is to raise interest rates. Now running around 2.2 percent, inflation has been at or above the top of the Fed's target range of 1 to 2 percent since early 2004. (That's going by the Fed's favorite inflation measure, the price deflator for personal consumption spending excluding food and energy.) By not raising interest rates to attack inflation, the Fed risks losing its hard-won credibility as a hawkish inflation fighter. If the public starts to expect higher inflation, prices will begin spiraling upward and the stability of the economy will be badly damaged.

So Bernanke and company are taking a big chance by leaving rates steady in the face of undesirably high inflation. Why are they taking this chance? Because they understand that raising rates creates its own set of problems—specifically, the big risk of sending the economy into a recession by raising rates too much.

So the Open Market Committee issued an artfully balanced statement. It said, "Recent readings on core inflation have been somewhat elevated." And it even kept the door open to more rate hikes, noting, "the Committee's predominant policy concern remains the risk that inflation will fail to moderate as expected."

But it took away the explicit mention of possible additional "firming." And it made clear that it cares about growth as well as inflation. It said any change in rates "will depend on the evolution of the outlook for both inflation and economic growth, as implied by incoming information."

Accounting for lag time
Give credit to Bernanke: He still wants to get inflation back under 2%, but he's willing to let it happen a little more slowly than he expected when he took over as chairman in February, 2006.

The U.S. economy really is like that car with the blacked-out windshield (so you can't see ahead) and with loose steering (so there's a big delay between the time you turn the steering wheel and the time you get results). Inflation, in particular, responds with a long lag to whatever the Federal Reserve does. It stays high for awhile even after the economy has begun to slow.

If the Fed didn't compensate for the lag, it might oversteer and put the economy in a ditch. Recognizing that, Bernanke and the other FOMC members are willing to allow some extra time to see if the tightening to date, from a funds rate of 1 percent to a current rate of 5.25 percent, will gradually cool inflation.

The last recession shows how long you sometimes have to wait to see inflation finally fall. In the late 1990s, the Fed raised rates nearly two percentage points to stamp out inflation. But the first victim of the rate hikes was growth. The economy tipped into a recession in March 2001.

Even then inflation stayed stubbornly high. Core inflation excluding food and energy prices didn't fall below 2 percent until January 2003, notes David Rosenberg, chief North American economist of Merrill Lynch. By then the Fed had already slashed interest rates more than five percentage points. A good thing, too—if the Fed had waited to cut rates until inflation had already fallen, the 2001 recession would have been much longer and deeper.

Stubbornly above-target inflation can't be easy for Bernanke and company to stomach. It's conspicuous evidence that they have failed, so far, to achieve their stated goal of long-term price stability. To their credit, though, they aren't steering rates higher. Because if they did, they might just steer the economy right off the road.

Copyright © 2012 Bloomberg L.P. All rights reserved.

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