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The Federal Reserve seems determined to make mistakes. First it started rumors that it would resume Treasury bond purchases, with the amount as high as $1 trillion. It seems all but certain this will happen once the midterm election passes.
Then the press reported rumors about plans to raise the inflation target to 4% or higher, from 2%. This is a major change from the Fed’s quick rejection of a higher target when the International Monetary Fund suggested it a few months ago.
Anyone can make a mistake, but wise people don’t repeat the same one. Increasing inflation to reduce unemployment initiated the Great Inflation of the 1960s and 1970s. Milton Friedman pointed out in 1968 why any gain in employment would be temporary: It would last only so long as people underestimated the rate of inflation. Friedman’s analysis is now a standard teaching of economics. Surely Fed economists understand this.
Adding another trillion dollars to the bank reserves by buying bonds will not relax a constraint that is holding back spending. There is no shortage of liquidity in the economy–banks already hold more than $1 trillion of reserves in excess of their legal requirements, and business balance sheets show an unprecedented amount of cash and near-cash assets. True, increasing bank reserves means mortgage rates will decline, at least temporarily; they already have in anticipation of the bond purchases. But neither the Fed nor the public should expect much stimulus as a result.
The most important restriction on investment today is not tight monetary policy, but uncertainty about administration policy. Businesses cannot know what their taxes, health-care, energy and regulatory costs will be, so they cannot know what return to expect on any new investment. They wait, hoping for a better day and an end to antibusiness pronouncements from the White House. President Obama could do more for the economy by declaring a three-year moratorium on new taxes and new regulation.
Homebuilding is a major employment industry. Lowering mortgage rates helps a bit, but it is small beer when the supply of unsold houses remains large. The only lasting solution for housing is to let prices fall to a new equilibrium. Painful, yes, but necessary. Temporary palliatives such as lower interest rates delay that adjustment.
The market’s response to the talk about renewed bond purchases includes a 12% or 13% decline in the value of the dollar against the euro. This depreciation occurred despite a weak euro, beset by potential crises in Ireland, Greece and Spain. The dollar’s decline is a strong market vote of no confidence in the proposed policy.
Once the economy does begin to heat up, the Fed will urgently need to reduce excess bank reserves lest they stoke inflation. The Fed has talked about policies it can use to do so, such as raising the interest rates it pays to banks to hold their reserves. It has not offered a coherent, credible program to do so since it does not say, and probably does not know, how high the market interest rate would have to be.
But that is always the critical issue because the administration, Congress, business, unions and much of the public will demand a looser monetary policy if interest rates rise above 5%. Adverse public reaction to higher interest rates has stopped anti-inflation policy many times in the past.
Today bond markets act as if they believe the Fed can reduce current excess bank reserves fast enough to avoid inflation above 2% or 3%. They do not share my skepticism. Will they remain sanguine when excess reserves increase to $2 trillion? Or will interest rates rise, pushed up by a flight from government bonds? That’s a risk that does not seem to bother many. Not yet, but it should, and it will.
One of the main reasons offered by some Fed governors and market portfolio managers for more stimulus is the fear of deflation. Yet the annual rate of increase in the consumer price index has remained between 1.2% and 2.5% every month this year. No evidence of deflation there. In fact, the Fed’s inflation target is said to be between 1% and 2%, just about where it is.
The fear of mild deflation is another mistake, one commonly made. In the almost 100 years of Federal Reserve history, periods when prices declined over several months have occurred seven times. Sometimes the deflation reached 30%, yet the recoveries that followed six of the deflations cannot be distinguished from any other post-recession recovery.
The exception, the seventh, was the Great Depression. Prices had fallen but were expected to fall faster because, under the gold standard then in operation, people responded to failing banks and collapsing output by hoarding gold, further contracting the money supply.
Yes, a sustained deflation would be a big problem, but it is unlikely in today’s circumstances. Countries with a depreciating exchange rate, an unsustainable budget deficit, and more than $1 trillion of excess monetary reserves are more likely to inflate. That’s our problem today, and it’s another reason the Fed should give up this nonsense about more stimulus and offer a credible long-term program to prevent the next inflation.
Allan H. Meltzer is a visiting scholar at AEI.
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