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View related content: Monetary Economics
In the 1970s, with inflation rising, I often described the Federal Reserve as
knowing only two speeds: too fast and too slow. At the time, the Fed’s idea was
to combat recession by promoting expansion, printing money and making it easier
for businesses and households to borrow–and worry only later about the
inflation that resulted. That strategy produced a sorry decade of slow
productivity growth, rising unemployment and, yes, rising inflation. If
President Obama and the Fed continue down their current path, we could see a
repeat of those dreadful inflationary years.
Back then, as now, the members of the Fed were well aware of the harmful
effects of inflation. In private, they vowed not to let it get out of hand and
several times even started to do something about it. But when their
anti-inflationary moves caused the unemployment rate to rise to 6.5 percent or 7
percent, they forgot their promises and again began expanding the money supply
and reducing interest rates.
By 1979, reported rates of inflation, worsened by the oil shock, had reached
double digits. Opinion polls showed that the public now considered inflation to
be the main economic problem. President Jimmy Carter’s choice for chairman of
the Fed, Paul Volcker, said that he would fight inflation more deliberately than
his predecessors. The president agreed with him, as did the chairmen of the
Congressional banking committees.
With the public acceptance of the importance of low inflation, support in the
administration and in Congress, and a chairman committed to the task, the Fed
finally set out to correct what it had too long neglected. Instead of working
only to avoid unemployment, the Fed sought to bring inflation back under
control. Instead of flooding the market and banks with money, the Fed tightened
its reserves. And instead of keeping interest rates in a narrow, relatively low
range, Mr. Volcker let the market dictate the interest rate, allowing the prime
rate to go as high as 21.5 percent. These disinflation policies continued in
earnest with the 1980 election of Ronald Reagan.
Even so, the public, having already seen three or four failed attempts to
tame inflation, didn’t really believe that Mr. Volcker and President Reagan
would stay the course. In my reading of the evidence, a decisive change in
attitudes occurred only in the spring of 1981, when the Federal Reserve raised
interest rates even though the unemployment rate was approaching 8 percent. This
was new. This was different. People began to expect lower inflation and, in this
belief, slowed the increase in wages and prices, contributing to the decline in
Naturally, there were critics. But their criticisms were not strong enough to
reverse policy. At the 1982 convention of the National Association of Home
Builders, Paul Volcker said that if he were to let up on anti-inflation efforts
prematurely, “the pain we have suffered would have been for naught–and we would
only be putting off until some later time an even more painful day of
reckoning.” As always in periods of high interest rates, home builders had been
especially badly hurt, but when the chairman finished his speech, they gave him
a standing ovation. Though they disliked his policy, they admired his
determination to do what was needed.
The pain did not end. And the anti-inflation policy continued until the
unemployment rate rose above 10 percent, many savings and loan institutions
faced bankruptcy, and most Latin American countries defaulted on their debt.
These were the unavoidable side effects of the public’s gradual adjustment to
the new economic environment. This process continued until 1983, when the
reported inflation rate fell below 4 percent.
Paul Volcker is now the head of President Obama’s Economic Recovery Advisory
Board. Mr. Volcker and the administration’s many economic advisers are all fully
aware of the inflationary dangers ahead. So is the current Fed chairman, Ben
Bernanake. And yet the interest rate the Fed controls is nearly zero; and the
enormous increase in bank reserves–caused by the Fed’s purchases of bonds and
mortgages–will surely bring on severe inflation if allowed to remain. Still,
they all reassure us that they can reduce reserves enough to prevent inflation
and they are committed to doing so.
I do not doubt their knowledge or technical ability. What I doubt is the
commitment of the administration and the autonomy of the Federal Reserve. Mr.
Volcker was a very independent chairman. But under Mr. Bernanke, the Fed has
sacrificed its independence and become the monetary arm of the Treasury: bailing
out A.I.G., taking on illiquid securities from Bear Stearns and promising to
provide as much as $700 billion of reserves to buy mortgages.
Independent central banks don’t do what this Fed has done. They leave such
fiscal action to the legislative branch. By that same token, Mr. Volcker’s Fed
had to avoid financing the large (for that time) Reagan budget deficits to be
able to bring down inflation. The central bank was made independent expressly so
that it could refuse to finance deficits. But is there a political consensus
that the much larger Obama deficits will not pressure the Fed to expand reserves
to buy Treasury bonds?
It doesn’t help that the administration’s stimulus program is an obstacle to
sound policy. It will create jobs at the cost of an enormous increase in the
government debt that has to be financed. And it does very little to increase
productivity, which is the main engine of economic growth.
Indeed, big, heavily subsidized programs are rarely good for productivity.
Better health care adds to the public’s sense of well-being, but it adds only a
little to productivity. Subsidizing cleaner energy projects can produce jobs,
but it doesn’t add much to national productivity. Meanwhile, higher carbon tax
rates increase production costs and prices but do not increase productivity. All
these actions can slow productive investment and the economy’s underlying growth
rate, which, in turn, increases the inflation rate.
Some of my fellow economists, including many at the Fed, say that the big
monetary goal is to avoid deflation. They point to the less than 1 percent
decline in the consumer price index for the year ending in March as evidence
that deflation is a threat. But this statistic is misleading: unstable food and
energy prices may lower the price index for a few months, but deflation (or
inflation) refers to the sustained rate of change of prices, not the price
level. We should look instead at a less volatile price index, the gross domestic
product deflator. In this year’s first quarter, it rose 2.9 percent–a sure sign
Besides, no country facing enormous budget deficits, rapid growth in the
money supply and the prospect of a sustained currency devaluation as we are has
ever experienced deflation. These factors are harbingers of inflation.
When will it come? Surely not right away. But sooner or later, we will see
the Fed, under pressure from Congress, the administration and business, try to
prevent interest rates from increasing. The proponents of lower rates will point
to the unemployment numbers and the slow recovery. That’s why the Fed must start
to demonstrate the kind of courage and independence it has not recently
Milton Friedman often said that “inflation was always and everywhere a
monetary phenomenon.” The members of the Federal Reserve seem to dismiss this
theory because they concentrate excessively on the near term and almost never
discuss the medium- and long-term consequences of their actions. That’s a big
error. They need to think past current political pressures and unemployment
rates. For the next few years, they cannot neglect rising inflation.
Allan H. Meltzer is a visiting scholar at AEI.
If President Obama and the Federal Reserve continue down their current path, we could see a repeat of the inflationary years of the 1970s.
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