There is plenty of room to debate what the Federal Reserve Board's monetary policy should be, but the necessary prerequisite for a serious debate is the knowledge of how monetary policy works. Readers of the Post would be badly misled on this topic by an article in today's paper. The article correctly reports that the Fed adjusts interest rates to prevent inflation from getting too high, explaining that "when inflation is a concern, it raises borrowing costs to cool economic growth, which weakens businesses' power to raise prices." Well, not exactly. The immediate target of the Fed's anti-inflation policy is wages, not prices. In fact, many macro-models have prices being a fixed mark-up over wages, which implies that the only way to control prices is to control wages. The Taylor rule, the standard guidepost for Fed policy, is based in part on the gap between a definition of full employment (the non-accelerating inflation rate of unemployment) and the current level of unemployment. This isn't being picky. The point is that the Fed slows inflation by raising the unemployment rate and throwing people out of work, thereby placing downward pressure on the wages of those who still have jobs. Disproportionately, the people who lose jobs tend to be less-skilled workers, manufacturing workers, sales clerks and custodians, not doctors, lawyers, and economists. The people who the Fed throws out of work are also disproportionately black and Hispanic. People can agree with Fed policy and think that controlling inflation is worth the cost in terms of higher unemployment and lower wages for these workers. However, we should not airbrush the picture. People will suffer for the Fed's decision to raise interest rates, and it will not be just businesses that have less ability to raise prices.
--Dean Baker
