“Paul Volcker is … 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.
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. …
…
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. They need to think past current political pressures and unemployment rates. For the next few years, they cannot neglect rising inflation.”
Allan H. Meltzer , “Inflation Nation”, The New York Times (3 May 2009).
http://www.nytimes.com/2009/05/04/opinion/04meltzer.html
Allan H. Meltzer, a professor of political economy at Carnegie Mellon University, is the author of “A History of the Federal Reserve.” He is considered one of the world's foremost experts on the development and applications of monetary policy.
Because of the great harm inflation can do to the economy and the fear that interest rates could be manipulated for political ends, the nation’s central bank has been placed beyond the direct control of democratic politics to an unusual degree. Its mandate, as stated in the Federal Reserve Act of 1913, as amended in section 2a, is to achieve three objectives:
“The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.
In order to carry out this responsibility the Fed has been granted great independence. It has been given both Target independence (that is, it is able to choose its own fundamental objectives) and Operational independence (that is, it is able to pursue its objectives as it sees fit, without interference or pressure from third parties). In this regard, it is recognized that it must have political independence from the government, technical independence in the sense of full control over the policy instruments it uses to attain its objectives, financial independence in the form of a secure capital base, and security of tenure of its key officials.
There is no question but that the Fed is a powerful institution. I tell my students that the Fed’s Open Market Committee, which sets American monetary policy, is the second most powerful committee in the world, trailing only the Joint Chiefs of Staff in its ability to affect developments across the globe. It can on its own and without limit or restraint reduce short-term interest rates by buying government securities, pumping cash into the economy and encouraging economic activity. Or it can raise short-term interest rates by selling government securities, taking cash out of the economy and dampening economic activity. Its demand and supply of Treasuries in the financial markets affects the entire term structure of U.S. interest rates and, given the key currency role of the U.S. dollar, interest rates in all other countries.
The threat to the independence of the Fed comes from the scale of the Fed’s interventions in credit markets in support of the Administration’s bailout and spending programs and its willingness to publically endorse measures undertaken by the Treasury.
During the past year the Fed has expanded the money supply by more than a trillion dollars and engaged in a wide range of activities which had the effect of lowering credit standards and loading its balance sheet with assets that that will be hard to unwind if it decides to change its policy stance. There is a growing concern that the Fed will refuse to withdraw the staggering quantity of liquidity it injected into the financial system once a revival in activity occurs for fear of prematurely ending any recovery. Any failure to raise interest rates and “take away the punchbowl just as the party gets going,” as a former Chairman of the Fed put it, would mean that rampant inflation could set in and the dollar could collapse on foreign exchange markets. Loss of control over inflation, the Fed’s single most important objective, would call into question its very independence.
Similarly, the Fed should avoid any appearance of supporting or not supporting actions taken by fiscal authorities, except in the most general and gentle way. It should never suggest anything that implies it is picking or choosing among companies or industries or financial concerns. To do so allows questions of favoritism and partiality to arise which are damaging to the central bank’s reputation. But to some degree it has done precisely this, supporting the Treasury’s decisions regarding macroeconomic policy. It has also joined with the Treasury in the financial realm in support of its policies. However, many feel it has overstepped its bounds by pressuring Bank of America and others in ways that reflect favoritism and in limiting the transparency of its operations.
Professor Meltzer is right to have expressed concerns about the Fed and how it has responded to the crisis. Some of us see a frightful storm of virulent inflation gathering on the horizon. While it will not be upon us any time soon, when it comes we believe it will come swiftly and it will be unstoppable except at great cost.
And we will blame the Fed for not only allowing this disaster to happen but for weakening the independence the central bank needs to sustain its reputation and keep political operatives at bay.
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