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In the 1970s, despite rising inflation, members of the Federal Reserve’s policy committee repeatedly chose to lower interest rates to reduce unemployment. Their Phillips Curve models, which charted an inverse relationship between unemployment and inflation, told them that inflation could wait and be addressed at a more opportune time. They were flummoxed when inflation and unemployment rose together throughout the decade.
In 1979, shortly after becoming Fed chairman, Paul Volcker told a Sunday talk-show audience that reducing inflation was the best way to reduce unemployment. He abandoned the faulty Phillips Curve thinking that unemployment was the enemy of inflation. And he told the Fed’s staff that while he thought highly of their work, he did not find their inflation forecasts useful. Instead of focusing on near-term output and employment, he changed the Fed’s policy to put more emphasis on the longer-term reduction of inflation. That required a persistent policy that President Reagan supported even in the severe 1982 recession.
We know the result: Inflation came down and stayed down. The Volcker disinflation ushered in two decades of low inflation and relatively steady growth, punctuated by a few short, mild recessions. And as Mr. Volcker predicted, the unemployment rate fell after the inflation rate fell. The dollar strengthened.
That was not unprecedented. The Phillips Curve often fails to forecast correctly. Spanish inflation has increased in the last year while the unemployment rate rose above 20%. Britain also has rising inflation and rising unemployment. Brazil lowered inflation and unemployment together. There are many other examples if only the Fed would look at them.
Throughout its modern history, the Fed has made several of the same policy mistakes repeatedly. Two are prominent now. It concentrates on near-term events over which it has little influence, and neglects the longer-term consequences of its operations. And it interprets its dual mandate as requiring it to direct all of its efforts to reducing unemployment when the unemployment rate rises. It does not have a credible long-term plan to reduce both current unemployment and future inflation, so it works on one at a time. This is an inefficient way to achieve a dual mandate. It failed totally during the Great Inflation of the 1970s. I believe it will fail again this time.
Commodity and some materials prices have increased dramatically in the past year. Countries everywhere face higher inflation. Despite the many problems in the euro area, the dollar has depreciated against the euro, a weak currency with many problems, suggesting that holders expect additional dollar weakness. Imports will cost more.
I believe it is foolhardy to expect businesses to absorb all the cost increases by holding prices unchanged. And loan demand has started to pick up, increasing the amount of money in circulation. It is a big mistake to expect that the U.S. will escape the inflation that is now rising throughout the world.
Because the Fed focuses on the near term, it tends to ignore changes in money-supply growth. This, too, is a mistake. Sustained inflation always follows increases in money-supply growth. Sustaining negative real interest rates (i.e., adjusted for inflation), as we have now, will cause this.
The Fed should make three changes. First, it should increase the short-term interest rate it controls to 1%, which would show that it is aware of the inflation risk and will act promptly to counteract it. Current low interest rates are an opportunity for the Fed to start reducing excess reserves.
Second, it should announce a specific, detailed plan that explains how it proposes to reduce about $900 billion of the more than $1 trillion banks continue to hold in excess of their legally required reserves.
Third, it should end QE2, its latest round of Treasury bond purchases. If, last November, the Fed had waited two more months before starting QE2, it would have known that a double-dip recession was not about to happen. Instead of waiting, the Fed responded to the cries coming from Wall Street.
Current slow growth and high unemployment is not mainly a monetary problem. The financial system has more than ample liquidity. Uncertainty about government policy is a much bigger problem. Businesses have had many reasons to be uncertain, to wait for a clearer outlook that would permit them to more accurately estimate future costs and returns to new investment. Better to hold cash and wait.
Until the 2010 election changed their view of the future, there was no way to know how much tax rates would increase, what new, costly regulations would stem from the president’s health-care reforms, the Dodd-Frank financial reforms, and elsewhere. The election reduced these concerns by giving control of the House to a majority that does not share President Obama’s vision that a good society should be directed and regulated from Washington. Last December, when Mr. Obama agreed to extend the Bush tax cuts, he showed that some improvement in outlook was justified. The economy responded.
What we need out of Washington now is spending reduction, lower corporate tax rates, and a three-year moratorium on new regulation. But perhaps most importantly, we need a new Fed policy to prevent 1970s-style inflation. Inflation is coming. Now is the time to head it off.
Allan H. Meltzer is a visiting scholar AEI.
Instead of the Fed focusing on short-term goals, their focus should be on long-term inflation reduction, encouraging businesses to be more certain with their investments.
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