There will be inflation. Massive inflation.
Usually I tend to quote Austrian school economists on this blog (as well as Milton Friedman), but since Meltzer is an Establishment economist, I thought a little background was important first.
Allan H. Meltzer is an American economist and professor of Political Economy at Carnegie Mellon University's Tepper School of Business in Pittsburgh, Pennsylvania. He was born February 6, 1928, in Boston, Massachusetts. He is the author of dozens of academic papers and books on monetary policy and the Federal Reserve Bank, and is considered one of the world's foremost experts on the development and applications of monetary policy. His book A History of the Federal Reserve is considered the most comprehensive history of the central bank. He is currently at work on Volume II of his History of the Federal Reserve Bank, which covers the years since the Federal Reserve accord in 1951 to the mid-1980s.
Dr. Meltzer served, from 1973 to 1999, as the Chair of the Shadow Open Market Committee, a group of economists, academics, and bankers that met to critique the actions of the Federal Reserve's Federal Open Market Committee. He served on the Council of Economic Advisors for both Presidents Kennedy and Reagan. He is currently a visiting scholar at the American Enterprise Institute.
Meltzer has written a couple important articles that should be taken very seriously. His opinions aren't for the government sycophants, nor Krugman minions.
This is for serious people only. So if you "believe" (blindly) in the government, this isn't for you. Stay ignorant at your own peril.
You may want to read this more than once.
This post will go back and forth between Meltzer's recent article and a follow-up written by Gary North titled, "Why Inflation Will Come."
The Fed's Anti-Inflation Exit Strategy Will Fail
Federal Reserve Chairman Ben Bernanke has explained his exit strategy to prevent future inflation. The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation.
I don't believe this will work, and no one else should.
The exit strategy is incomplete. Proponents are guilty of practicing economics without prices. They never say what the interest rate on reserves must be to get banks to hold the approximately $1 trillion of reserves above the minimum they're legally required to hold. That's the critical question.
Gary North: [T]his is not a policy of unwinding, i.e., a reversal of the FED's expansion of its balance sheet. This is a policy of sterilization. The money put on deposit with the FED is not loaned into the economy. This negates the effect of the fractional reserve process. Money not spent into circulation is money that does not multiply.
The monetary base serves as the legal foundation of a future expansion of money. All it will take to begin the expansion is a series of decisions by commercial bankers to pull their banks' money away from the FED. The act of removing these funds creates the loans. With the exception of reserves held at the FED, every entry on the liability (deposits) side of a bank's ledger must be offset by assets (loans). Banks cannot withdraw reserves without lending.
Normally, banks' principal business is lending, and the interest rate they can get on their loans is more important than the interest they might get on their reserves. Once borrowing resumes, banks will increase loans and expand deposits. The current massive volume of excess reserves will melt into a greater money supply, and later higher inflation.
When will inflation start? The date is uncertain. But the triggering event will be either a sustained increase in bank lending or a large increase in Fed purchases of government debt. Perhaps both. Either one would trigger a sustained increase in money growth.
Gary North: The key word here is "normally." Times are not normal.
Today, the Fed Funds rate is between 0% and 0.25% – essentially nothing. Why? Because most banks are not lending to anyone. They have built up excess reserves to the tune of a trillion dollars. So, banks are not under any pressure to borrow overnight money. The fed funds rate has fallen.
What this means is that the FED is not setting the federal funds rate. Banks are. All of the FED's press announcements about setting the fed funds rate is nothing but PR flak. There is no rate to set. Banks are not borrowing, because they are not lending. They are holding excess reserves.
The date is uncertain, because bankers are not acting normally. They are squirreling away money at the FED, which sterilizes this money.
The Federal Reserve has a well-known dual mandate to prevent both inflation and unemployment. It chooses to act on only one part of its mandate at a time. That cannot be the best way to achieve both targets, and it has failed repeatedly to bring low inflation and low unemployment. For example, the policy implied by the famous Phillips Curve—which says you can trade off higher inflation for lower unemployment—failed in the 1970s. We got rising inflation and higher unemployment.
Gary North: In the 1970's, the FED's policies produced the worst of both worlds: high unemployment and high price inflation. Meltzer does not say this, but this unwanted pair of outcomes were what brought Keynesianism into question. This was the decade in which Chicago School monetarism finally got a hearing. (Austrian School economics has yet to gain a hearing among academic economists and policy-makers.)
[T]he Fed should announce a policy for preventing inflation that reduces the enormous stock of excess reserves, such as by selling securities. And the Treasury or the Office of Management and Budget should announce a credible policy for reducing deficits. That would help to reduce the uncertainty about future taxes, spending and inflation.
Policies without prices hide the serious problem posed by excessive debt and reserves, and are not credible.
Gary North: This refers to the payment of interest on bank reserves. The policy is not only not credible; the policy is irrelevant. It is not FED policy that is keeping the Fed Funds rate at under 0.25%. It is the overall capital market. Banks are not lending to borrowers, so they are not borrowing overnight reserves from each other.
The Business Cycle
The Austrian theory of the business cycle, announced by Ludwig von Mises in 1912, is that an inflated money supply leads to price distortions in the capital markets. These distortions promote investment in lines of production that will produce losses when the money supply stops growing – not just shrinks, but merely stops growing.
The Federal Reserve has expanded its purchases of debt ever since early September 2008. The increase in excess reserves offset most of this increase. Capital has therefore shifted to government and away from private capital markets. The FED acts on behalf of the Treasury and also Fannie and Freddie.
Because the FED is spending but banks are not lending, there is an increase in the government's component of the gross domestic product. This will have repercussions next year and thereafter: the expansion of the Federal government's percentage of the GDP.
If the FED pursues this policy of buying Treasury and F/F debt, the economy will not go into recession until later – maybe 2011. But the FED has insisted that it will cease buying F/F debt after March 31.
It now faces the creation of a secondary recession. The price effects of its expansion of money in 2008 have been muted. This is because of the rise of commercial bank reserves.
Meltzer is not an Austrian School economist. He may believe that the FED can start selling off assets until it winds down the increase of Sept/Oct 2008. It can't. That would create another Great Depression.
Inflation Nation
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.
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.
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.
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.
Allan Meltzer, The New York Times: Inflation Nation
I can't stress enough how important this is for you to know and understand. Paper currencies always fail, just as do central banks.
It isn't a matter of being "optimistic," "believing in America," or "animal spirits" either. Despite what Tony Robbins may say, confidence can't change reality.
The dollar is doomed. There will be (hyper) inflation.
