Vi= ew=20 this Outlook as a PDF
Subscribe=20 to the Economic Outlook = series
As one of the most powerful influences on the = US=20 economy, the Federal Reserve is bearing the brunt of=20 significant criticism during this global economic = crisis.=20 Though some of this criticism is certainly justified, = other=20 suggestions about monetary policies the Fed should = pursue to=20 boost the economy are counterproductive. Many critics = have=20 taken issue with the Fed=E2=80=99s current = accommodative stance, but=20 an increase in interest rates or reserve draining = could=20 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=20 collapse and associated panic triggered a global = financial=20 crisis and a sharp global economic slowdown. = Policymakers=20 fought back after the crisis with easier monetary and = fiscal=20 =C2=ACpolicies that boosted growth and stock prices. = After a US=20 deflation scare in the summer of 2010, another round = of=20 quantitative easing (QE2) from the US Federal Reserve = and=20 another fiscal stimulus package in late 2010 boosted=20 confidence, if not growth, at least until last = spring.
As growth has slowed in the United States and = Europe and=20 fears of a return to financial crisis and recession = have=20 intensified, policy actions, especially those of the = Fed, have=20 come under increasing scrutiny from members of = Congress; the=20 media; and, most recently, presidential candidates. = Although=20 some of the criticism is justified, some assertions = are simply=20 wrong and, if taken seriously, could exacerbate the = crisis the=20 world economy and financial markets are now = facing.
The three primary myths surrounding the = Fed=E2=80=99s actions are=20 (1) the Fed is pursuing a policy of printing money = that will=20 result in higher inflation and possibly even eventual=20 hyperinflation; (2) a gold standard would be the best = policy=20 for the United States to assure price stability; and = (3) by=20 printing money, the Fed is enabling expansionary = fiscal policy=20 and larger budget deficits.
A Path to Hyperinflation?
The first criticism is that the Fed=E2=80=99s zero = interest rate=20 policy and expansion of its balance sheet by nearly $2 = trillion since 2008 is causing higher inflation and = risking=20 hyperinflation. Fed critics primarily cite as evidence = higher=20 US inflation, as well as the higher gold price and = weaker=20 dollar, each of which has appeared at various times = over the=20 past year.
The path of US headline inflation is instructive. = During=20 the onset of the financial crisis in 2008, US headline = inflation rose to almost 6 percent on a year-over-year = basis,=20 and after the onset of the Lehman crisis, it plunged = to below=20 2 percent by mid-2009. It is true that aggressive = global=20 stimulus boosted US headline inflation back up to 2.5 = percent=20 by the end of 2010 and up to 3.9 percent on a = year-over-year=20 basis during the first three quarters of 2011. Most of = the=20 headline inflation increase is due to rises in = volatile food=20 and energy prices, some of which have been driven = higher by=20 the stronger recovery in emerging economies, = especially China.=20 It is worth noting that recovery in those countries is = waning=20 as their central banks tighten monetary policy.
The core year-over-year consumer price inflation = index=20 dropped steadily from about 2.5 percent in mid-2008 to = below=20 0.5 percent, year-over-year, in September 2010. The = plunge in=20 core inflation to this level triggered the = Fed=E2=80=99s deflation=20 alert, which caused it to move aggressively with QE1. = Since=20 then, core inflation has risen to 2 percent, = year-over-year,=20 hardly runaway but exactly what the Fed was aiming for = to=20 counter the risk of a costly deflation=E2=80=94the = last thing a=20 policymaker wants in the midst of a global financial = crisis,=20 especially given the current risk of a double-dip=20 recession.
Headline and core inflation are starting to = decrease. The=20 rapid slowdown in the global economy and sharp drop in = global=20 wealth by $6=E2=80=937 trillion since summer will slow = global demand=20 growth. We are already seeing two signs inflation may = be=20 slowing: the trade-weighted US dollar is more than 4 = percent=20 off its July lows, and the price of gold, about $1,700 = an=20 ounce, is well below its earlier peak of more than = $1,900 an=20 ounce.
The latest core inflation data through September = show the=20 three-month annualized pace decelerating from more = than 3=20 percent during the second quarter to 2.1 percent = during the=20 third quarter. (See figure 1, solid line.) The monthly = annualized core inflation rate has dropped even more = sharply.=20 (See figure 1, dashed line.) The largest contribution = to the=20 rise in the core inflation rate has, somewhat = incongruously,=20 come from housing; as homeowners are abandoning = mortgages on=20 homes where prices have collapsed and moving into = rental=20 units, higher rents are creating the illusion that = house=20 prices are rising because of the misleading way the = official=20 measure of housing costs is constructed. Core = inflation=20 exclusive of rents decelerated even more rapidly = during the=20 third quarter than overall core inflation.
Even with signs of a moderate headline inflation = comeback=20 that has fallen far short of the 6 percent pace that = appeared=20 in mid-2008 just before the Lehman crisis, Fed critics = continue to focus on rising headline inflation. How, = then, do=20 these critics who foresee higher runaway inflation in = the=20 future think the Fed should act to prevent this = outcome?=20 Should it drain liquidity from the banking system? = Should it=20 raise the federal funds rate? The latter move could = prove=20 economically disastrous: not only would the Fed be = breaking=20 its promise to hold the rate close to zero for the = next few=20 years, but the resulting expected economic slowdown = would=20 invert the yield curve. Short-term interest rates = would=20 surpass long-term rates, clearly signaling a future = recession.=20 The dollar would strengthen, at least until the US = economy=20 totally collapsed, and the risk of deflation would = replace the=20 risk of inflation. Fears of inflation caused the Fed = to=20 tighten in 1931, reducing the money supply by a third = and=20 sharply intensifying the Great Depression. Perhaps the = negative implications of a tighter monetary policy = explain why=20 few of the Fed=E2=80=99s critics have specifically = suggested that it=20 should tighten policy, even though this would seem the = most=20 obvious solution if they believe the Fed is following=20 dangerous inflationary policies.
The Gold Standard
Would moving to a gold standard be the best policy = to=20 address the US economic woes? Under the = post=E2=80=93World War II gold=20 exchange standard, the dollar was pegged to gold at = $35 an=20 ounce. The ability to convert the dollar into gold = boosted the=20 demand for the dollar as an international reserve and = enhanced=20 US ability to borrow to finance its external = imbalances,=20 resulting in higher inflation in the United States and = an=20 eventual breakdown of the gold exchange standard when=20 then-president Richard M. Nixon effectively closed the = gold=20 window in August 1971. Advocates of a gold standard = may have=20 in mind a system where too much US demand growth and = rising=20 external deficits force an outflow of US gold, a = reduction in=20 US money supply, and a fall in the US consumer price = level.=20 What actually happened when US inflation picked up in = the late=20 1960s and early 1970s was an outflow of US gold, but = rather=20 than reduce its money supply and pursue effectively = tighter=20 monetary policies, the United States simply = unilaterally ended=20 the gold standard.
The experience after the US gold window was closed = in=20 August 1971 is revealing. At first, foreign countries, = especially in Europe, demanded a sharp devaluation of = the=20 dollar. But when then-Treasury secretary John Connally = offered=20 a 20 percent devaluation, which would have caused a = dramatic=20 increase in the competitiveness of US goods in global = markets,=20 the rest of the G7 was ultimately happy to settle for = an=20 approximately 8 percent dollar devaluation. Just as = the=20 Chinese have been willing to accumulate more than $1 = trillion=20 in US dollar reserves to keep their currency from = appreciating=20 against the US dollar and preserve access to US and = other=20 global markets, other members of the G7 in 1971 were = willing=20 to accommodate the United States with a small = effective dollar=20 devaluation to maintain their access to US markets. Of = course,=20 that artificial system only lasted about thirteen = months=20 before being blown apart by divergent economic = policies within=20 the G7. This was good because the late-1973 oil shock = required=20 a substantially different set of exchange rates among = the=20 world=E2=80=99s major trading nations.
Money Growth and = Inflation =20
As they express fears about runaway inflation, the = Fed=E2=80=99s=20 critics seem to be suggesting it is flooding the US = economy=20 with unwanted liquidity that is accommodating = excessive=20 government spending growth. It is important to = distinguish=20 between situations in which rapid money growth is=20 accommodating a sharp increase in the demand for money = and=20 those in which it is creating an excess supply of = money. The=20 Fed has rapidly expanded the monetary base with = aggressive=20 purchases of assets, including mortgage-backed = securities and=20 Treasuries. This $2 trillion-plus expansion of the = Fed=E2=80=99s=20 balance sheet has greatly expanded bank reserves, and = since=20 July, the money supply (M2) has risen. A persistent = rise in=20 the excess supply of money generated by = disproportionate Fed=20 money creation would create higher inflation, a much = weaker=20 dollar, and higher prices for gold and other safe = havens. In=20 fact, as already noted, since the Fed followed its QE2 = policy=20 with another modest step toward quantitative easing in = the=20 form of Operation Twist, the price of gold has = actually come=20 down and the trade-weighted dollar has = strengthened.
The jump in the US M2 money supply since July has = been=20 largely driven by a sharp increase in demand deposits. = It=20 appears that many US households that are selling = stocks and=20 risky bonds are depositing the cash they accrue in=20 FDIC-insured bank accounts. Firms are adding cash to = FDIC=20 insured accounts, as well. The resulting surge in = demand=20 deposits and the M2 money supply as the economy and = nominal=20 GDP have been relatively stagnant has sharply = depressed M2=20 velocity (the ratio of GDP to the money supply). The = drop in=20 velocity is a classic sign that households and firms = are=20 responding to the high level of economic uncertainty = by=20 accumulating cash to hold rather than accumulating = cash to=20 spend as economic activity picks up.
To always ascribe higher inflation to faster money = growth=20 requires that the demand for money be stable. Under = the usual=20 analysis, faster money growth is seen to create higher = expected inflation, which in turn reduces the demand = for money=20 and further exacerbates inflation pressure. The = behavior of=20 inflation expectations over the past months has been = quite=20 different, though, suggesting that the rise in M2 = holdings=20 does not portend an inflation surge. The Fed=E2=80=99s = favorite=20 measure of inflation is the five-year forward expected = inflation rate, or the inflation rate expected to = prevail from=20 five to ten years out. In July, that expected = inflation rate=20 was well over 3 percent. By the end of September, it = had=20 fallen to 2.2 percent, and since then it has risen = only=20 modestly back to 2.4 percent. Other measures of = expected=20 inflation have been similarly well-behaved.
A fall in expected inflation strongly suggests a = scenario=20 in which the demand for cash is rising more rapidly = than=20 supply. Take a look at the yield on short-term = Treasuries,=20 which is virtually zero. Why are people willing to = hold=20 Treasury bills that are essentially yielding zero = (that is,=20 cash equivalents) if they are expecting inflation to = run away?=20 Keynes=E2=80=99s precautionary motive again comes to = mind. Investors=20 are so fearful that the value of riskier assets will = drop that=20 they rush into cash and drive the yield on short-term = cash=20 equivalents like Treasury bills to zero. Similarly, = the yield=20 on longer-term Treasuries has dropped consistently = since=20 spring. The yield on thirty-year Treasury bonds has = dropped=20 from over 4 percent to 3 percent because investors are = so=20 anxious to hold safe assets (cash equivalents or = nearly so)=20 that they bid yields on these instruments to levels = below=20 those that prevailed during the height of the = post-Lehman=20 crisis.
The reality is that in the period after a financial = crisis,=20 the path of inflation can be highly unstable. When a = central=20 bank is aggressively adding liquidity and the = government is=20 introducing fiscal stimulus, as it was at the end of = 2010, the=20 prices of risky assets and yields on Treasuries rise, = and=20 investors expect higher yields from stocks and = commodities and=20 a fast growing economy. If the stimulus fails, as it = had by=20 summer of this year, investors move back into less = risky=20 assets and the demand for cash rises. If the Fed then = tightens=20 or withdraws liquidity, the excess demand for cash = further=20 reduces the demand for commodities, goods, and = services, and=20 disinflation and deflation can emerge rapidly. Those = phenomena=20 cause even more demand for cash, and unless the = central bank=20 responds aggressively to prevent deflation, growth = slows and=20 the economy is stuck in a deflationary liquidity trap. = This=20 was the unfortunate experience during the Great = Depression and=20 in Japan after 1999.
Chairman Ben Bernanke and the rest of the Fed are = not=20 unaware of these risks, nor of the risks of higher = inflation.=20 Were the economy to recover and households and = businesses to=20 show a desire to reduce their cash holdings, bidding = up the=20 demand for labor, goods, and services along with = prices, the=20 Fed would reduce its highly accommodative stance. But = the Fed=20 has indicated it would undertake a further = quantitative easing=20 if signs of a still-weaker economy or deflation = emerge. This=20 action appears more likely, especially given the = substantial=20 risks to the global economy from the turmoil in the = European=20 financial system that creates a further demand for = safe assets=20 and imparts a deflationary bias to the US economy. The = goal of=20 further quantitative easing would be to accommodate a = rapid=20 increase in the demand for liquid assets that, if = unsatisfied,=20 would cause accelerated deflation that would further=20 exacerbate the financial crisis. The crisis is, after = all,=20 about the real burden of debt, which rises sharply if=20 inflation drops or becomes deflation because the real = cost of=20 repaying debts increases.
Fed critics need to remember that the = responsibility of a=20 central bank is price stability. That translates into = avoiding=20 an inflation rate above a preannounced target, = currently=20 between 1.5 and 2 percent, to account for upward = biases in the=20 price level, and avoiding deflation or falling prices, = especially in periods after financial crises when = households=20 are saddled with excessive debts. After the inflation = of the=20 1970s, driven in part by excessive government spending = and=20 large external increases in energy prices, the Fed for = a time=20 lost control of inflation, which became = self-reinforcing until=20 it was well over 12=E2=80=9314 percent per year by = 1979 and 1980. At=20 that time, the Fed encountered criticism as intense as = Bernanke is facing today because it was battling = higher=20 inflation with significantly tighter monetary = policy.
We more typically think of a central bank fighting=20 inflation than fighting deflation, though the latter = is often=20 necessary in the aftermath of a financial crisis. = Surely a=20 steady monitoring of Fed actions by Congress can be=20 constructive, and the Fed has been attempting to make = its=20 actions more transparent to accommodate such scrutiny. = However, blanket calls for the Fed to reverse its = current=20 accommodative stance because of claims that inflation = is about=20 to surge are not justified by the facts, and if they = are=20 followed by an increase in interest rates or with = reserve=20 draining, the weak global economy will surely collapse = and=20 provide us with an even worse dilemma than we now = face.
John H. Makin is a resident scholar at = AEI.
' + projectFeatures[index][2] + = '
Vi= ew=20 this Outlook as a PDF
Subscribe=20 to the Economic Outlook = series
As one of the most powerful influences on the = US=20 economy, the Federal Reserve is bearing the brunt of=20 significant criticism during this global economic = crisis.=20 Though some of this criticism is certainly justified, = other=20 suggestions about monetary policies the Fed should = pursue to=20 boost the economy are counterproductive. Many critics = have=20 taken issue with the Fed=E2=80=99s current = accommodative stance, but=20 an increase in interest rates or reserve draining = could=20 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=20 collapse and associated panic triggered a global = financial=20 crisis and a sharp global economic slowdown. = Policymakers=20 fought back after the crisis with easier monetary and = fiscal=20 =C2=ACpolicies that boosted growth and stock prices. = After a US=20 deflation scare in the summer of 2010, another round = of=20 quantitative easing (QE2) from the US Federal Reserve = and=20 another fiscal stimulus package in late 2010 boosted=20 confidence, if not growth, at least until last = spring.
As growth has slowed in the United States and = Europe and=20 fears of a return to financial crisis and recession = have=20 intensified, policy actions, especially those of the = Fed, have=20 come under increasing scrutiny from members of = Congress; the=20 media; and, most recently, presidential candidates. = Although=20 some of the criticism is justified, some assertions = are simply=20 wrong and, if taken seriously, could exacerbate the = crisis the=20 world economy and financial markets are now = facing.
The three primary myths surrounding the = Fed=E2=80=99s actions are=20 (1) the Fed is pursuing a policy of printing money = that will=20 result in higher inflation and possibly even eventual=20 hyperinflation; (2) a gold standard would be the best = policy=20 for the United States to assure price stability; and = (3) by=20 printing money, the Fed is enabling expansionary = fiscal policy=20 and larger budget deficits.
A Path to Hyperinflation?
The first criticism is that the Fed=E2=80=99s zero = interest rate=20 policy and expansion of its balance sheet by nearly $2 = trillion since 2008 is causing higher inflation and = risking=20 hyperinflation. Fed critics primarily cite as evidence = higher=20 US inflation, as well as the higher gold price and = weaker=20 dollar, each of which has appeared at various times = over the=20 past year.
The path of US headline inflation is instructive. = During=20 the onset of the financial crisis in 2008, US headline = inflation rose to almost 6 percent on a year-over-year = basis,=20 and after the onset of the Lehman crisis, it plunged = to below=20 2 percent by mid-2009. It is true that aggressive = global=20 stimulus boosted US headline inflation back up to 2.5 = percent=20 by the end of 2010 and up to 3.9 percent on a = year-over-year=20 basis during the first three quarters of 2011. Most of = the=20 headline inflation increase is due to rises in = volatile food=20 and energy prices, some of which have been driven = higher by=20 the stronger recovery in emerging economies, = especially China.=20 It is worth noting that recovery in those countries is = waning=20 as their central banks tighten monetary policy.
The core year-over-year consumer price inflation = index=20 dropped steadily from about 2.5 percent in mid-2008 to = below=20 0.5 percent, year-over-year, in September 2010. The = plunge in=20 core inflation to this level triggered the = Fed=E2=80=99s deflation=20 alert, which caused it to move aggressively with QE1. = Since=20 then, core inflation has risen to 2 percent, = year-over-year,=20 hardly runaway but exactly what the Fed was aiming for = to=20 counter the risk of a costly deflation=E2=80=94the = last thing a=20 policymaker wants in the midst of a global financial = crisis,=20 especially given the current risk of a double-dip=20 recession.
Headline and core inflation are starting to = decrease. The=20 rapid slowdown in the global economy and sharp drop in = global=20 wealth by $6=E2=80=937 trillion since summer will slow = global demand=20 growth. We are already seeing two signs inflation may = be=20 slowing: the trade-weighted US dollar is more than 4 = percent=20 off its July lows, and the price of gold, about $1,700 = an=20 ounce, is well below its earlier peak of more than = $1,900 an=20 ounce.
The latest core inflation data through September = show the=20 three-month annualized pace decelerating from more = than 3=20 percent during the second quarter to 2.1 percent = during the=20 third quarter. (See figure 1, solid line.) The monthly = annualized core inflation rate has dropped even more = sharply.=20 (See figure 1, dashed line.) The largest contribution = to the=20 rise in the core inflation rate has, somewhat = incongruously,=20 come from housing; as homeowners are abandoning = mortgages on=20 homes where prices have collapsed and moving into = rental=20 units, higher rents are creating the illusion that = house=20 prices are rising because of the misleading way the = official=20 measure of housing costs is constructed. Core = inflation=20 exclusive of rents decelerated even more rapidly = during the=20 third quarter than overall core inflation.
Even with signs of a moderate headline inflation = comeback=20 that has fallen far short of the 6 percent pace that = appeared=20 in mid-2008 just before the Lehman crisis, Fed critics = continue to focus on rising headline inflation. How, = then, do=20 these critics who foresee higher runaway inflation in = the=20 future think the Fed should act to prevent this = outcome?=20 Should it drain liquidity from the banking system? = Should it=20 raise the federal funds rate? The latter move could = prove=20 economically disastrous: not only would the Fed be = breaking=20 its promise to hold the rate close to zero for the = next few=20 years, but the resulting expected economic slowdown = would=20 invert the yield curve. Short-term interest rates = would=20 surpass long-term rates, clearly signaling a future = recession.=20 The dollar would strengthen, at least until the US = economy=20 totally collapsed, and the risk of deflation would = replace the=20 risk of inflation. Fears of inflation caused the Fed = to=20 tighten in 1931, reducing the money supply by a third = and=20 sharply intensifying the Great Depression. Perhaps the = negative implications of a tighter monetary policy = explain why=20 few of the Fed=E2=80=99s critics have specifically = suggested that it=20 should tighten policy, even though this would seem the = most=20 obvious solution if they believe the Fed is following=20 dangerous inflationary policies.
The Gold Standard
Would moving to a gold standard be the best policy = to=20 address the US economic woes? Under the = post=E2=80=93World War II gold=20 exchange standard, the dollar was pegged to gold at = $35 an=20 ounce. The ability to convert the dollar into gold = boosted the=20 demand for the dollar as an international reserve and = enhanced=20 US ability to borrow to finance its external = imbalances,=20 resulting in higher inflation in the United States and = an=20 eventual breakdown of the gold exchange standard when=20 then-president Richard M. Nixon effectively closed the = gold=20 window in August 1971. Advocates of a gold standard = may have=20 in mind a system where too much US demand growth and = rising=20 external deficits force an outflow of US gold, a = reduction in=20 US money supply, and a fall in the US consumer price = level.=20 What actually happened when US inflation picked up in = the late=20 1960s and early 1970s was an outflow of US gold, but = rather=20 than reduce its money supply and pursue effectively = tighter=20 monetary policies, the United States simply = unilaterally ended=20 the gold standard.
The experience after the US gold window was closed = in=20 August 1971 is revealing. At first, foreign countries, = especially in Europe, demanded a sharp devaluation of = the=20 dollar. But when then-Treasury secretary John Connally = offered=20 a 20 percent devaluation, which would have caused a = dramatic=20 increase in the competitiveness of US goods in global = markets,=20 the rest of the G7 was ultimately happy to settle for = an=20 approximately 8 percent dollar devaluation. Just as = the=20 Chinese have been willing to accumulate more than $1 = trillion=20 in US dollar reserves to keep their currency from = appreciating=20 against the US dollar and preserve access to US and = other=20 global markets, other members of the G7 in 1971 were = willing=20 to accommodate the United States with a small = effective dollar=20 devaluation to maintain their access to US markets. Of = course,=20 that artificial system only lasted about thirteen = months=20 before being blown apart by divergent economic = policies within=20 the G7. This was good because the late-1973 oil shock = required=20 a substantially different set of exchange rates among = the=20 world=E2=80=99s major trading nations.
Money Growth and = Inflation =20
As they express fears about runaway inflation, the = Fed=E2=80=99s=20 critics seem to be suggesting it is flooding the US = economy=20 with unwanted liquidity that is accommodating = excessive=20 government spending growth. It is important to = distinguish=20 between situations in which rapid money growth is=20 accommodating a sharp increase in the demand for money = and=20 those in which it is creating an excess supply of = money. The=20 Fed has rapidly expanded the monetary base with = aggressive=20 purchases of assets, including mortgage-backed = securities and=20 Treasuries. This $2 trillion-plus expansion of the = Fed=E2=80=99s=20 balance sheet has greatly expanded bank reserves, and = since=20 July, the money supply (M2) has risen. A persistent = rise in=20 the excess supply of money generated by = disproportionate Fed=20 money creation would create higher inflation, a much = weaker=20 dollar, and higher prices for gold and other safe = havens. In=20 fact, as already noted, since the Fed followed its QE2 = policy=20 with another modest step toward quantitative easing in = the=20 form of Operation Twist, the price of gold has = actually come=20 down and the trade-weighted dollar has = strengthened.
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