Meltzer: Are We Tough Enough For The Coming Inflation Battle?

“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.”

Allan H. Meltzer, May 3rd 2009

In Allan Meltzer’s excellent New York Times op-ed piece from May 3rd, we are taken back to the late 70’s, when runaway inflation spread sluggishness, unemployment and low productivity throughout the land.  Meltzer is one of the foremost Fed watchers and Fed historians and is currently an economics professor at Carnegie Mellon.

Then Federal Reserve Chairman Paul Volcker came in during Carter‘s administration and even in the face of political pressure over the climbing jobless numbers, was able to act as an independent central banker and fight runaway inflation with market-dictated higher interest rates, even as unemployment rose past 6.5% and then past 7%.  By 1983, his dogged pursuit of lower prices and costs became a victory, even though the unemployment rate had at one point read above 10%.

With the public acceptance of the importance of low inflation, support in the administration and in Congress, and a chairman committed to the task, the Fed finally set out to correct what it had too long neglected. Instead of working only to avoid unemployment, the Fed sought to bring inflation back under control. Instead of flooding the market and banks with money, the Fed tightened its reserves.

Volcker’s determination and independence from the legislative branch enabled him to do what was necessary, even when it unpopular.  His rationale for allowing a 21.5% interest rate in the 1980’s, was that if we didn’t take our medicine now, it would taste much worse in the future.  He delivered this message at a speech to a homebuilders’ association meeting and actually received a round of applause, even though the rates were killing them.  They got the point that he was looking longer term.

The trouble with our now-politicized Federal Reserve is that it no longer has the independence to do the necessary, politically difficult things it will need to do to fight the coming inflation battle.  Meltzer sites the involvement of the Fed with the AIG bailout and it’s subservience to the Treasury as two examples of this.

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

Having a politicized Fed means that like anything else that gets overly concerned with politics, elections start to intefere with and influence the decision making process.  Will Bernanke be able to or have the will to jack interest rates up in the face of 7, 9, 11% unemployment if necessary?  Will Obama’s administration allow it even if he did?

The good news, according to Meltzer, is that Volcker is in the Obama fold…

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.

That said, the warning is clear:

But sooner or later, we will see the Fed, under pressure from Congress, the administration and business, try to prevent interest rates from increasing. The proponents of lower rates will point to the unemployment numbers and the slow recovery. That’s why the Fed must start to demonstrate the kind of courage and independence it has not recently shown.

Full Story: Meltzer’s Inlfation Nation (NYT)

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Discussions found on the web
  1. Mark T commented on May 06

    And so it begins. Policy has always been set by the bond markets and the influence (sometimes conscious, sometimes not) of their economists and strategists. Policy advice is always construed in such a way as to be good for bonds. Thus the dramatic “need” to cut short term rates in the US to help the housing market in 2007 when in truth 75% (now 90%) of mortgages are fixed for an average of 28 years did nothing for the housing market and a lot for bond managers’ profits. The deflation scare to reach for ZIRP and thus continue to deliver capital gains to the prop books has now passed and long rates are backing up, all else being equal towards a “normal” rate of interest. Now, of course, they will cry inflation and demand sharply higher rates, and coincidentally flatten the yield curve to deliver profit for the prop books at the long end. If they can throw in a spanner to the hated equity market, so much the better.

  2. Mark T commented on May 06

    And so it begins. Policy has always been set by the bond markets and the influence (sometimes conscious, sometimes not) of their economists and strategists. Policy advice is always construed in such a way as to be good for bonds. Thus the dramatic “need” to cut short term rates in the US to help the housing market in 2007 when in truth 75% (now 90%) of mortgages are fixed for an average of 28 years did nothing for the housing market and a lot for bond managers’ profits. The deflation scare to reach for ZIRP and thus continue to deliver capital gains to the prop books has now passed and long rates are backing up, all else being equal towards a “normal” rate of interest. Now, of course, they will cry inflation and demand sharply higher rates, and coincidentally flatten the yield curve to deliver profit for the prop books at the long end. If they can throw in a spanner to the hated equity market, so much the better.

  3. Mark T commented on May 06

    And so it begins. Policy has always been set by the bond markets and the influence (sometimes conscious, sometimes not) of their economists and strategists. Policy advice is always construed in such a way as to be good for bonds. Thus the dramatic “need” to cut short term rates in the US to help the housing market in 2007 when in truth 75% (now 90%) of mortgages are fixed for an average of 28 years did nothing for the housing market and a lot for bond managers’ profits. The deflation scare to reach for ZIRP and thus continue to deliver capital gains to the prop books has now passed and long rates are backing up, all else being equal towards a “normal” rate of interest. Now, of course, they will cry inflation and demand sharply higher rates, and coincidentally flatten the yield curve to deliver profit for the prop books at the long end. If they can throw in a spanner to the hated equity market, so much the better.

  4. Dr. Doom on Hyperinflation « The Reformed Broker commented on May 27

    […] I have frequently been discussing the possibility of hyperinflation both with clients and here on TRB.  Earlier this month, I featured an op-ed by Dr. Allan Meltzer on inflation fighting. […]

  5. Dr. Doom on Hyperinflation « The Reformed Broker commented on May 27

    […] I have frequently been discussing the possibility of hyperinflation both with clients and here on TRB.  Earlier this month, I featured an op-ed by Dr. Allan Meltzer on inflation fighting. […]

  6. Dr. Doom on Hyperinflation « The Reformed Broker commented on May 27

    […] I have frequently been discussing the possibility of hyperinflation both with clients and here on TRB.  Earlier this month, I featured an op-ed by Dr. Allan Meltzer on inflation fighting. […]