Smith Faculty Opinion Article
The 30 Seconds Outlook
November 15, 2010
“. . . 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, Wall Street Journal, October 11, 2010
Professor Meltzer recently completed Volume 2 of his monumental A History of
the Federal Reserve. He finds the Fed makes two basic types of policy errors:
(1) giving in to “political interference or pressure,” and (2) policy based on
“mistaken beliefs.” Successful monetary policy avoids these errors and failed
policy makes one or both of these errors. The Great Recession provides ample
evidence of both types of policy errors.
Based on what the Fed says, it appears quite determined to continue to make
mistakes. In this case it is the Fed’s upcoming Quantitative Easing that would
involve purchasing $1 trillion in Treasury bonds, which would create unneeded
liquidity in efforts to preclude deflation and reduce unemployment. But why?
Banks already have $1 trillion in excess reserves and businesses are cash rich.
The falling dollar also reflects global lack of confidence in this action.
Inflation, not deflation, is the more likely outcome and this action would
contribute to it. Increasing inflation to produce a temporary reduction in
unemployment was the basis for the Great Inflations of the 1960s and 1970s.
Temporary reductions last only as long as the rate of inflation is
underestimated.
Once economic growth begins to spark a serious increase in prices, the Fed
will need to reduce bank reserves to raise interest rates and to dampen
inflation. But, how high will the interest rate have to be?
Given the Fed’s recent history of loose monetary policy for reasons not
exclusively those of an independent Fed, it is most likely we will experience
serious inflation. The result appears consistent with what markets are telling
us—high political based economic uncertainty, record gold prices and the falling
dollar, positive sloped Treasury yield curve highly correlated with expected
inflation, increasing utilization of manufacturing capacity, loosened bank
credit standards, among others.
The current loose monetary policy with very low interest rates also increases
investor appetite for risk in the search for yield—a major contributor to the
speculative bubble that preceded the 2007-2009 financial crisis.
John A. Haslem
