Yesterday, the Federal Open Markets Committee decided, under the guidance of chairman Ben Bernanke, to engage in a new round of quantitative easing (open market purchases of mortgage backed securities at a rate of $40 billion per month for as long as necessary) and also promised to keep interest rates at extraordinarily low levels through 2015.  I'd remind people, by the way, that the Fed could hike rates 200 basis points and still claim to be at historically very low levels (we'd be just over 2 percent).

With inflation at 2%, the Fed has tremendous flexibility to act.  If inflation does emerge, the Fed can always crush it with rate hikes in short order.  While I'd rather see more aggressive measures taken to put money in the hands of middle class people, Bernanke is probably right that it's up to the elected government to do that.  As Fed chairman, it is clearly his right to use his unlimited balance sheet to buy whatever assets he deems prudent in order to keep the credit markets functioning cheaply.  He's chosen mortgage-backeds to start, but I saw a Goldman Sachs note yesterday that speculates that U.S. Treasuries would also be a possibility if Bernanke feels the need for additional stimulus.  By purchasing Treasuries, the Fed can keep the government's borrowing costs low, giving the government enormous policy flexibility, though even Bernanke can't beat gridlock.

Romney's campaign wants to spin the Fed decision as proof that Obama's policies have failed and that the President needs a bailout.  The Atlantic reports that David Vitter knows what's going on:

"Sen. David Vitter, R-La., who supports the Senate version of the Fed-audit legislation, condemned the Fed's actions on Thursday. "Chairman Bernanke and the Federal Open Market Committee are clearly feeling tremendous pressure to bail out the economy because of President Obama's struggle to turn around the jobless numbers," he said in a statement.

"The cost of this open-ended easy money policy dramatically outweighs the short term benefits. The Fed's move today puts us on the fast track to rampant inflation and potentially a return to a world with twenty percent interest rates," he said."

It is possible, of course, that inflation could creep up on us without being noticed by the official government measures.  Some complain, for example, that energy and fuel prices, which are volatile, are excluded from the core* inflation measure, causing some inflation watchers to understate the problem.  Hookers and adult sex diapers are also not in the basket of goods, so Vitter might feel the pinch before the rest of the country.

But this is just damned ridiculous.  Bernanke is not going to allow 20% inflation.  He has so many freaking options to stop it, it's crazy to worry about.  His inflation target is like 2-3%, not 15%.

So, what happens if Bernanke wakes up one day and sees inflation headed to 5% or 6%?  Well, the first thing he can do, on a moment's notice, is he can stop buying assets in the open market.  This would take liquidity out of the system and cause some deflation.  He can go from adding assets to the Feds balance sheet to selling them, which would bring asset prices down and would counter inflation.  And, of course, with interest rates between 0% and .25%, Bernanke and company could raise rates 500 basis points in a year and still be at a level that, at most times in history, would be considered accommodative.

Bernanke would face a big problem if inflation were to leap up while unemployment remains high.  This is unlikely to happen, however, because it's the high unemployment (and stagnant wages) that are depressing demand and keeping inflation low in the first place.  If we see some serious inflation, it'll likely be a sign that something else is working.  Then, Bernanke will have his chance and building a "Goldilocks" scenario where he and the committee can try to get things just right.

Bernanke's critics are worried about a repeat of 1970s stagflation where high input prices, particularly in energy, led to massive inflation alongside high unemployment as U.S. businesses started to compete in globalization's infancy.  On one hand, I think the world's a different place.  Goods move through markets more cheaply and more efficiently.  We communicate better.  We have trade agreements.  This all makes a 70s repeat less likely.  But if I'm wrong about that, the Fed chairman will know exactly what to do because he saw Paul Volcker squash inflation by massively raising rates.  It will be easier for Bernanke, by the way, to raise rates from zero than it was for Volcker, who had to raise rates from a much higher level.

It seems to me that the Fed did a pretty good job yesterday.  He didn't bail out Obama.  He volleyed the ball back to the elected government, which now has ample freedom to act.  At this point, the recovery is the government's to lose.  If Republicans think that Bernanke is on Obama's side that's probably because he is.  The Fed chairman has been saying for years that Congress needs to do something other than obstruct.  He can't help it if Congress is amused by or tolerant of other people's suffering.

*Originally,  said that food and energy prices are excluded from the "standard" measure of inflation.  DF points out below that I was absolutely wrong.  My mistake doesn't even make sense in the context of later paragraphs where I discuss the 1970s.  I should have said "core inflation," and have amend the post accordingly. -D23