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US Treasury Department
As one of the most powerful influences on the US economy, the Federal Reserve is bearing the brunt of significant criticism during this global economic crisis. Though some of this criticism is certainly justified, other suggestions about monetary policies the Fed should pursue to boost the economy are counterproductive. Many critics have taken issue with the Fed’s current accommodative stance, but an increase in interest rates or reserve draining could ultimately cause greater harm to the already faltering economy.
Key points in this Outlook:
It has been more than three years since the Lehman Brothers collapse and associated panic triggered a global financial crisis and a sharp global economic slowdown. Policymakers fought back after the crisis with easier monetary and fiscal ¬policies that boosted growth and stock prices. After a US deflation scare in the summer of 2010, another round of quantitative easing (QE2) from the US Federal Reserve and another fiscal stimulus package in late 2010 boosted confidence, if not growth, at least until last spring.
As growth has slowed in the United States and Europe and fears of a return to financial crisis and recession have intensified, policy actions, especially those of the Fed, have come under increasing scrutiny from members of Congress; the media; and, most recently, presidential candidates. Although some of the criticism is justified, some assertions are simply wrong and, if taken seriously, could exacerbate the crisis the world economy and financial markets are now facing.
“Though higher inflation is a concern, the threat of deflation in this economic environment is far more worrisome, which explains the Fed’s sensible focus on price stability.”–John Makin
The three primary myths surrounding the Fed’s actions are (1) the Fed is pursuing a policy of printing money that will result in higher inflation and possibly even eventual hyperinflation; (2) a gold standard would be the best policy for the United States to assure price stability; and (3) by printing money, the Fed is enabling expansionary fiscal policy and larger budget deficits.
A Path to Hyperinflation?
The first criticism is that the Fed’s zero interest rate policy and expansion of its balance sheet by nearly $2 trillion since 2008 is causing higher inflation and risking hyperinflation. Fed critics primarily cite as evidence higher US inflation, as well as the higher gold price and weaker dollar, each of which has appeared at various times over the past year.
The path of US headline inflation is instructive. During the onset of the financial crisis in 2008, US headline inflation rose to almost 6 percent on a year-over-year basis, and after the onset of the Lehman crisis, it plunged to below 2 percent by mid-2009. It is true that aggressive global stimulus boosted US headline inflation back up to 2.5 percent by the end of 2010 and up to 3.9 percent on a year-over-year basis during the first three quarters of 2011. Most of the headline inflation increase is due to rises in volatile food and energy prices, some of which have been driven higher by the stronger recovery in emerging economies, especially China. It is worth noting that recovery in those countries is waning as their central banks tighten monetary policy.
The core year-over-year consumer price inflation index dropped steadily from about 2.5 percent in mid-2008 to below 0.5 percent, year-over-year, in September 2010. The plunge in core inflation to this level triggered the Fed’s deflation alert, which caused it to move aggressively with QE1. Since then, core inflation has risen to 2 percent, year-over-year, hardly runaway but exactly what the Fed was aiming for to counter the risk of a costly deflation—the last thing a policymaker wants in the midst of a global financial crisis, especially given the current risk of a double-dip recession.
Headline and core inflation are starting to decrease. The rapid slowdown in the global economy and sharp drop in global wealth by $6–7 trillion since summer will slow global demand growth. We are already seeing two signs inflation may be slowing: the trade-weighted US dollar is more than 4 percent off its July lows, and the price of gold, about $1,700 an ounce, is well below its earlier peak of more than $1,900 an ounce.
The latest core inflation data through September show the three-month annualized pace decelerating from more than 3 percent during the second quarter to 2.1 percent during the third quarter. (See figure 1, solid line.) The monthly annualized core inflation rate has dropped even more sharply. (See figure 1, dashed line.) The largest contribution to the rise in the core inflation rate has, somewhat incongruously, come from housing; as homeowners are abandoning mortgages on homes where prices have collapsed and moving into rental units, higher rents are creating the illusion that house prices are rising because of the misleading way the official measure of housing costs is constructed. Core inflation exclusive of rents decelerated even more rapidly during the third quarter than overall core inflation.
Even with signs of a moderate headline inflation comeback that has fallen far short of the 6 percent pace that appeared in mid-2008 just before the Lehman crisis, Fed critics continue to focus on rising headline inflation. How, then, do these critics who foresee higher runaway inflation in the future think the Fed should act to prevent this outcome? Should it drain liquidity from the banking system? Should it raise the federal funds rate? The latter move could prove economically disastrous: not only would the Fed be breaking its promise to hold the rate close to zero for the next few years, but the resulting expected economic slowdown would invert the yield curve. Short-term interest rates would surpass long-term rates, clearly signaling a future recession. The dollar would strengthen, at least until the US economy totally collapsed, and the risk of deflation would replace the risk of inflation. Fears of inflation caused the Fed to tighten in 1931, reducing the money supply by a third and sharply intensifying the Great Depression. Perhaps the negative implications of a tighter monetary policy explain why few of the Fed’s critics have specifically suggested that it should tighten policy, even though this would seem the most obvious solution if they believe the Fed is following dangerous inflationary policies.
The Gold Standard
Would moving to a gold standard be the best policy to address the US economic woes? Under the post–World War II gold exchange standard, the dollar was pegged to gold at $35 an ounce. The ability to convert the dollar into gold boosted the demand for the dollar as an international reserve and enhanced US ability to borrow to finance its external imbalances, resulting in higher inflation in the United States and an eventual breakdown of the gold exchange standard when then-president Richard M. Nixon effectively closed the gold window in August 1971. Advocates of a gold standard may have in mind a system where too much US demand growth and rising external deficits force an outflow of US gold, a reduction in US money supply, and a fall in the US consumer price level. What actually happened when US inflation picked up in the late 1960s and early 1970s was an outflow of US gold, but rather than reduce its money supply and pursue effectively tighter monetary policies, the United States simply unilaterally ended the gold standard.
The experience after the US gold window was closed in August 1971 is revealing. At first, foreign countries, especially in Europe, demanded a sharp devaluation of the dollar. But when then-Treasury secretary John Connally offered a 20 percent devaluation, which would have caused a dramatic increase in the competitiveness of US goods in global markets, the rest of the G7 was ultimately happy to settle for an approximately 8 percent dollar devaluation. Just as the Chinese have been willing to accumulate more than $1 trillion in US dollar reserves to keep their currency from appreciating against the US dollar and preserve access to US and other global markets, other members of the G7 in 1971 were willing to accommodate the United States with a small effective dollar devaluation to maintain their access to US markets. Of course, that artificial system only lasted about thirteen months before being blown apart by divergent economic policies within the G7. This was good because the late-1973 oil shock required a substantially different set of exchange rates among the world’s major trading nations.
Money Growth and Inflation
As they express fears about runaway inflation, the Fed’s critics seem to be suggesting it is flooding the US economy with unwanted liquidity that is accommodating excessive government spending growth. It is important to distinguish between situations in which rapid money growth is accommodating a sharp increase in the demand for money and those in which it is creating an excess supply of money. The Fed has rapidly expanded the monetary base with aggressive purchases of assets, including mortgage-backed securities and Treasuries. This $2 trillion-plus expansion of the Fed’s balance sheet has greatly expanded bank reserves, and since July, the money supply (M2) has risen. A persistent rise in the excess supply of money generated by disproportionate Fed money creation would create higher inflation, a much weaker dollar, and higher prices for gold and other safe havens. In fact, as already noted, since the Fed followed its QE2 policy with another modest step toward quantitative easing in the form of Operation Twist, the price of gold has actually come down and the trade-weighted dollar has strengthened.
The jump in the US M2 money supply since July has been largely driven by a sharp increase in demand deposits. It appears that many US households that are selling stocks and risky bonds are depositing the cash they accrue in FDIC-insured bank accounts. Firms are adding cash to FDIC insured accounts, as well. The resulting surge in demand deposits and the M2 money supply as the economy and nominal GDP have been relatively stagnant has sharply depressed M2 velocity (the ratio of GDP to the money supply). The drop in velocity is a classic sign that households and firms are responding to the high level of economic uncertainty by accumulating cash to hold rather than accumulating cash to spend as economic activity picks up.
“A fall in expected inflation strongly suggests a scenario in which the demand for cash is rising more rapidly than supply.”–John Makin
To always ascribe higher inflation to faster money growth requires that the demand for money be stable. Under the usual analysis, faster money growth is seen to create higher expected inflation, which in turn reduces the demand for money and further exacerbates inflation pressure. The behavior of inflation expectations over the past months has been quite different, though, suggesting that the rise in M2 holdings does not portend an inflation surge. The Fed’s favorite measure of inflation is the five-year forward expected inflation rate, or the inflation rate expected to prevail from five to ten years out. In July, that expected inflation rate was well over 3 percent. By the end of September, it had fallen to 2.2 percent, and since then it has risen only modestly back to 2.4 percent. Other measures of expected inflation have been similarly well-behaved.
A fall in expected inflation strongly suggests a scenario in which the demand for cash is rising more rapidly than supply. Take a look at the yield on short-term Treasuries, which is virtually zero. Why are people willing to hold Treasury bills that are essentially yielding zero (that is, cash equivalents) if they are expecting inflation to run away? Keynes’s precautionary motive again comes to mind. Investors are so fearful that the value of riskier assets will drop that they rush into cash and drive the yield on short-term cash equivalents like Treasury bills to zero. Similarly, the yield on longer-term Treasuries has dropped consistently since spring. The yield on thirty-year Treasury bonds has dropped from over 4 percent to 3 percent because investors are so anxious to hold safe assets (cash equivalents or nearly so) that they bid yields on these instruments to levels below those that prevailed during the height of the post-Lehman crisis.
The reality is that in the period after a financial crisis, the path of inflation can be highly unstable. When a central bank is aggressively adding liquidity and the government is introducing fiscal stimulus, as it was at the end of 2010, the prices of risky assets and yields on Treasuries rise, and investors expect higher yields from stocks and commodities and a fast growing economy. If the stimulus fails, as it had by summer of this year, investors move back into less risky assets and the demand for cash rises. If the Fed then tightens or withdraws liquidity, the excess demand for cash further reduces the demand for commodities, goods, and services, and disinflation and deflation can emerge rapidly. Those phenomena cause even more demand for cash, and unless the central bank responds aggressively to prevent deflation, growth slows and the economy is stuck in a deflationary liquidity trap. This was the unfortunate experience during the Great Depression and in Japan after 1999.
Chairman Ben Bernanke and the rest of the Fed are not unaware of these risks, nor of the risks of higher inflation. Were the economy to recover and households and businesses to show a desire to reduce their cash holdings, bidding up the demand for labor, goods, and services along with prices, the Fed would reduce its highly accommodative stance. But the Fed has indicated it would undertake a further quantitative easing if signs of a still-weaker economy or deflation emerge. This action appears more likely, especially given the substantial risks to the global economy from the turmoil in the European financial system that creates a further demand for safe assets and imparts a deflationary bias to the US economy. The goal of further quantitative easing would be to accommodate a rapid increase in the demand for liquid assets that, if unsatisfied, would cause accelerated deflation that would further exacerbate the financial crisis. The crisis is, after all, about the real burden of debt, which rises sharply if inflation drops or becomes deflation because the real cost of repaying debts increases.
Fed critics need to remember that the responsibility of a central bank is price stability. That translates into avoiding an inflation rate above a preannounced target, currently between 1.5 and 2 percent, to account for upward biases in the price level, and avoiding deflation or falling prices, especially in periods after financial crises when households are saddled with excessive debts. After the inflation of the 1970s, driven in part by excessive government spending and large external increases in energy prices, the Fed for a time lost control of inflation, which became self-reinforcing until it was well over 12–14 percent per year by 1979 and 1980. At that time, the Fed encountered criticism as intense as Bernanke is facing today because it was battling higher inflation with significantly tighter monetary policy.
We more typically think of a central bank fighting inflation than fighting deflation, though the latter is often necessary in the aftermath of a financial crisis. Surely a steady monitoring of Fed actions by Congress can be constructive, and the Fed has been attempting to make its actions more transparent to accommodate such scrutiny. However, blanket calls for the Fed to reverse its current accommodative stance because of claims that inflation is about to surge are not justified by the facts, and if they are followed by an increase in interest rates or with reserve draining, the weak global economy will surely collapse and provide us with an even worse dilemma than we now face.
John H. Makin is a resident scholar at AEI
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