Monday, May 4, 2009

Inflation Nation

I've held economist Allan Meltzer in the highest regard ever since he reviewed a draft of a report I wrote on the outlook for Argentina in 1981. His understanding of monetary policy and inflation is almost without peer; his understanding of markets is excellent; and his understanding of how all this mixes with politics is as good as anything I've seen. I would highly recommend his article "Inflation Nation" in today's N.Y. Times. Key excerpts:

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.

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.

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 of inflation.

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 shown.
We've got the essential ingredients for a sustained increase in inflation: a huge expansion of the Fed's balance sheet, which has resulted in a mind-boggling ten-fold increase in bank reserves since last summer; a Fed that is now buying Treasury bonds by the tens of billions, and mortgage-backed securities by the hundreds of billions; an economy that will probably experience a tepid recovery; an unemployment rate that will remain uncomfortably high for some time; and a president who believes deep down inside that pulling government policy levers can fix just about any problem that upsets people.

Now that the economy is coming out of its deep-seated panic, the public's demand for liquidity will start to decline. Money will be spent instead of being hoarded. Banks will become more eager to lend, and borrowers more eager to borrow, rather than deleverage. If the Fed doesn't reverse course soon, and if the Obama administration doesn't offer them its full support and encouragement, we will have not just a weak recovery to worry about, but rising inflation as well.

UPDATE: In his May 5th testimony, Bernanke makes it clear that the Fed thinks weak economic growth will keep inflation low. Remarkably, his summary of the main sources of inflation (inflation expectations and economic resource slack) does not include actions taken by the Fed.


dave said...

Keynesian economist need to add a couple new words to their lexicon. Two that come to mind are "contraction and expansion. If they could comprehend their meaning they would understand that growth is not necessarily inflationary and recessions not deflationary. They are like the carpenter who only has a hammer and thinks everything is a nail.

Bernard said...


I tend to agree and have positioned my portfolio for that outcome but I worry about an unexpected deflationary event(s).

If Milton Friedman is correct, then there should be inflation with 99% confidence assuming the Fed does not have the will power to raise rates while un-employment hovers around 8-10%. With the intermingling of the Fed and Mr Market that seems like a safe bet but what bothers me is that everyone is talking up the same game.


Scott Grannis said...

dave: Studying the history of ARgentina would also help. They have experienced massive recession and triple digit inflation simultaneously.

Bernard: Not everyone is talking about inflation, and so far inflation expectations remain quite subdued. you can see that in the level of Treasury yields, and the Treasury-TIPS spread. Also, the dollar is about in the middle of its historic range, and gold hasn't gone up for the past year or so. The extra money pumped in hasn't yet exceeded the demand for it--that is the key. We have to wait for signs that that is changing.

prophets said...

I find Meltzer's remarks to be fairly one sided. I'm not sure how he can lay out such a tacit indictment of Bernanke while essentially giving the administration(s) (Obama/Bush) a complete pass on the issues faced in the financial crisis.

Independence is important. Inflation is coming. These are real issues, but to wag your finger at Bernanke while ignoring the lack of solutions from Treasury is totally preposterous.

Scott Grannis said...

Good point. I think Meltzer was a bit too indirect with his criticism. He did refer to the importance of Reagan's explicit support of Volcker, but he didn't follow through and say clearly that Obama a) needed to follow through and do the same and b) shouldn't be asking the Fed to do all that it has done to date. I suppose it's difficult for an academic to boldly criticize a president these days, especially a Democratic president.