The Fed’s Hawkish Stance - CBS MoneyWatch.com: Why such a hawkish stance among the members of the Fed?... [T]here is more to the hawkishness than worry about the Fed’s expansionary policy to combat the recession. There is also the longer run issue of how the federal budget deficit might affect monetary policy. If the deficit is not reined in, and if interest rates begin to rise as the economy recovers - as they certainly will at some point, though not any time soon - then the Fed will need to decide how to respond.... The hawkishness we are seeing presently is, in part, a signal to Congress that if they don’t get the budget under control, they cannot count on the Fed to bail them out through inflationary debt monetization. The Fed is sending a very clear message that it will raise interest rates rather than let inflation become a problem even if that means slowing the economy and increasing unemployment.
But there is a danger here. Members of Congress may use this message about the difficulties deficits pose for monetary policy to bolster their efforts to pass budget reductions in the short-run that do very little to solve the long-run budget problem. For example, the GOP’s proposal to cut $61 billion from discretionary spending through cuts in programs such as Head Start and Pell Grants will do almost nothing to solve the long-run deficit problem, which is driven primarily by rising health care costs, but it could slow the recovery substantially.
The Fed cannot allow itself to be pushed into debt monetization by Congress, so communication along these lines is appropriate. However, how this message is communicated is critical.... Those Fed members who think that tighter monetary or fiscal policy is in the short-run will be harmful need to make it clear that although it’s important to solve the long-run budget problem, short-run contraction could be harmful and it could actually work against fixing the long-run problem.... [I]mmediate cuts to programs that have little or nothing to do with the long-run budget problem will harm the recovery, give the public a false sense of security that Congress is making headway on the budget problem, and it will not avoid the need to address the long-run budget issue down the road. The members of the Fed who understand this reality must do a better job of letting the public know that the current budget proposals would dim employment prospects, do almost nothing about the long-run budget problem, and make it much more likely that the Fed will face difficult choices in the future.