Bernanke's dilemma: Ignore politics

Why the Fed chairman should ignore Congress and start tightening up soon.

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By Allan H. Meltzer, contributor

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(Fortune Magazine) -- After two years of pumping money into the financial system to keep the economy afloat, Fed Chairman Ben Bernanke will have to reverse the process or risk an opposite problem: inflation.

After much anticipation, he announced in July the Fed's "exit strategy" from its vast intervention, declaring it will happen "in a smooth and timely manner."

It's reassuring that Fed officials are aware of the inflation risk, but their program is unlikely to succeed. Much research shows that it takes about two years for anti-inflation policy to work. That means the Fed needs to start now and stick with it.

I do not doubt the Fed's ability to control inflation; however, history warns that we should be skeptical of the Fed's willingness to sustain the program when pressured to abandon it by so many powerful forces: Congress, the Obama administration, the business community, and labor unions.

Sustaining the program requires accepting a temporary medium-term increase in unemployment and interest rates and maintaining a degree of independence that this Fed has not shown.

I am skeptical too about the adequacy of the program that the chairman proposed. The Fed has to remove most of the remaining $700 billion increase in bank reserves that it supplied in the past year before the banks use them to increase money growth.

The Fed has two responses.

One is that many of the reserves will disappear as banks and others repay the special-purpose loans that followed the Lehman bankruptcy last September. While the Fed's balance sheet has started to shrink, much of that reflects reduced demand for credit because of the weak economy -- and it won't bring about the needed increase in long-term rates.

The second part of Bernanke's program depends on a power the Fed acquired recently. It can now pay interest on bank reserves, so it claims that banks will willingly hold more reserves to earn interest instead of lending. But how much more will banks hold? Surely less than the $500 billion or $600 billion of excess reserves.

Once the economy recovers, banks will start to lend to their customers and attract new ones. The Fed must be willing to let lending and bond rates rise as banks reduce their reserves. Many influential voices will complain that letting rates rise will prolong the recession.

This problem repeats the experience of 1966-67, 1969-70, 1973-75, and other times. Outside pressures on the Fed increased when the unemployment rate reached about 6.5% or 7%, well below its current or prospective level. That ended the anti-inflation commitment.

There is only one exception: the Volcker disinflation of 1979-82. Paul Volcker was the most independent chairman in the Fed's modern history. When President Carter interviewed him, Volcker told the President that he would follow a less inflationary policy than his predecessors. To his surprise, Carter said, "That's what I want." The change reflected a major shift in public opinion. For the first time the public told pollsters that inflation, which reached 17% at one point, was the most serious economic problem the country faced.

In the 1980 presidential election, the public chose Ronald Reagan, who promised to end inflation. Unemployment rates rose above 10% and shortterm interest rates reached 20% during the disinflation. But in less than two years inflation fell to about 4%. Gradually we entered a long period of stable growth, mild inflation, and short recessions that lasted until 2006.

Are the Obama administration, Congress, and the public willing to tolerate high nominal interest rates and higher unemployment? Very unlikely. The chairman has stated "at some point ... as economic recovery takes hold, we will need to tighten monetary policy."

But since he and his colleagues don't see that point being reached anytime soon, by the time we get there it may well be too late.

Allan H. Meltzer is the Allan H. Meltzer University Professor of Political Economy at Carnegie Mellon and the author of A History of the Federal Reserve. To top of page

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