Uneasy Money

Allan Meltzer has had a long and distinguished career as an economist and scholar, making many notable contributions to monetary economics at both the theoretical and empirical levels, also writing valuable and highly regarded contributions to the history of economics and economic history, especially his 1989 book on Keynes and his recent monumental two-volume history of the Federal Reserve System. Meltzer has the added virtue of being a UCLA-trained economist, where as a student he began his long collaboration with his teacher Karl Brunner. So I take no pleasure in writing this post about what can only be described as an embarrassment, namely, the abysmal op-ed article (“What’s Wrong with the Federal Reserve?”) Meltzer wrote in today’s Wall Street Journal about the Fed and current monetary policy.

Meltzer immediately gets off to a bad start, from which he never recovers, with the following opening sentence.

By allowing its monetary policy to be influenced by elected politicians and market speculators, the Federal Reserve is putting its independence at risk.

Now you might have thought that a serious charge about the Fed’s conduct would require some supporting evidence that the Fed’s policy was being influenced by either politicians or speculators. Well, this is what seems to count as evidence for Professor Meltzer.

Consider the response to last week’s employment report for June—a meager 80,000 net new jobs created, and an unemployment rate stuck at 8.2%. Day traders and speculators immediately clamored for additional monetary easing. Even the president of the Federal Reserve Bank of Chicago joined in.

So the people that Professor Meltzer thinks are now controlling Fed policy are a bunch of day traders. This goes way past what even Ron Paul would say about who is controlling the Fed, i.e., international bankers (aka the Rothschilds). No, it’s a conspiracy of the day traders, apparently having co-opted the president of the Chicago Federal Reserve Bank. Talk about lowering the bar. But it gets worse. Let’s read on.

To his credit, Mr. Bernanke did not immediately agree. But he failed utterly to state the obvious: The country’s sluggish growth and stubbornly high unemployment rate was [sic] not caused by, nor could it [sic] be cured by, monetary policy.

OK, Professor Meltzer has discovered that the Fed is being controlled by a conspiracy of day traders working through the president of the Chicago Fed.  Except that Bernanke and the FOMC (except for that guy from Chicago) did not go along with the conspirators! What then is the evidence that Fed policy is controlled by the day traders? Apparently, the failure of Bernanke to make an abject admission of the Fed’s impotence.

Now what is Professor Meltzer’s evidence for the Fed’s impotence? Let him speak for himself:

Market interest rates on all maturities of government bonds are the lowest since the founding of the republic.

This is astonishing. Allan Meltzer is widely regarded as a founding fathers (along with Milton Friedman and Karl Brunner) of modern Moneterism, one of whose basic tenets is that nominal interest rates are primarily determined by inflation expectations. Thus, low interest rates, as Milton Friedman always pointed out, are symptomatic of tight monetary policy that keeps inflation, and inflation expectations, low, as they are now. But somehow Professor Meltzer has now concluded, like the Keynesians that Monetarists once disputed, that low interest rates are symptomatic of easy money. Meltzer later invokes Friedman’s authority to support the proposition that monetary policy is an unreliable instrument for stabilizing short-term fluctuations in the economy, causing one to wonder whether his memory lapses are random or selective.

Professor Meltzer’s memory of recent economic history is also dubious. Discussing the Fed’s adoption of QE2 in the fall of 2010, he writes:

Consider also how, in the summer of 2010, the Fed allowed itself to be spooked by cries about a double-dip recession and deflation. It added $600 billion to banks’ reserves by buying up federal Treasurys and mortgage-backed securities. Today, $500 billion of those reserves remain on bank balance sheets, and most of the rest of the dollars are held by foreign central banks. Not much help to the U.S. economy. By early autumn 2010, it had become clear that fears of a double-dip recession and deflation were just short-term hysteria.

Actually, Chairman Bernanke only signaled in late August and early September 2010 that the Fed would engage in renewed quantitative easing, thereby producing an immediate market response. The renewed purchases did not begin until the autumn. What became clear in the autumn was not that recession and deflation fears were just short-term hysteria, but that quantitative easing prevented the slide into recession that had been anticipated by a sharp dive in the stock market in August 2010.

Meltzer asserts that the cause of the weak recovery is uncertainty about future tax rates, health-care costs, and the regulatory burden. One would expect that, as an accomplished empirical economist, Professor Meltzer would attempt to back up his assertion with evidence. But he apparently regards it as too self-evident a proposition to require any empirical support.

Professor Meltzer again displays a shockingly cavalier attitude toward empirical evidence with the following assertion:

Evidence is growing that many think higher inflation is in our future. One sign is the premium that investors pay to hold index-linked Treasury bonds that protect against inflation.

These claims about inflation expectations are not backed up by data of any kind, even though they are readily available. The only problem is that the data don’t support Meltzer’s claims.  Breakeven TIPS spreads have edged up slightly in the last couple of weeks as fears of an imminent financial crisis in Europe have eased, but even at the 10-year time horizon the breakeven rate is barely above 2%, which is less than inflation expectations have been for most of the nearly four years since the onset of the financial crisis in 2008. And according to the estimates of inflation expectations by the Cleveland Fed, 10-year inflation expectations in June were at an all-time low, about 1.2%.

Although there is much more to criticize about this piece, it would be churlish to continue further. But I cannot help wonder why Professor Meltzer is so heedless of his reputation that he would allow his name to be attached to a piece of work so far below not just his own formerly high standards, but even below a standard of minimal competence. My only conjecture is that Rupert Murdoch is somehow responsible. Perhaps Murdoch has cast a demonic spell on Professor Meltzer. That seems as good an explanation as any.

In the wake of the FOMC’s decision Wednesday to ignore reality (and its own forecasts), the stock market dove yesterday. Inflation expectations, as approximated by the breakeven TIPS spread, also dove. And for the first time since March 2009, when the S&P 500 fell below 700, the implied breakeven TIPS spread on a one-year Treasury turned negative. I point this out just to illustrate the gravity of the current situation, not because there is a huge difference between the expectation of slightly positive inflation and slightly negative deflation.

Check out this chart for the one-year breakeven TIPS spread, this one for the 2-year, this one for the 5-year, and this one for the 10-year.

Chairman Bernanke has been reduced to defending the indefensible. Paul Krugman properly castigated the FOMC’s abdication of responsibility this week. Scott Sumner believes that Bernanke’s heart is in the right place, but his hands are tied, and is therefore unable to do what he knows in his heart ought to be done. If Scott is right, then Bernanke has only one honorable course of action: to resign and to explain that he cannot continue to serve as Fed Chairman, presiding over, and complicit in, a policy that he knows is mistaken and leading us to disaster.

At its meeting today, the Federal Open Market Committee (FOMC) decided . . . , well, decided not to decide. Faced with a feeble US economic recovery showing clear signs of getting weaker still, and a perilous economic situation in Europe poised to spin out of control into a full-blown financial crisis, the FOMC opted to continue the status quo, prolonging its so-called Operation Twist in which the Fed is liquidating its holdings of short-dated Treasuries and replacing them with longer-dated Treasuries, on the theory that changing the maturity structure of the Fed’s balance sheet will reduce long-term interest rates, thereby providing some further incentive for long-term borrowing, as if the problem holding back a recovery were long-term nominal interest rates that are not low enough.

What I found most interesting in today’s statement was the FOMC’s assessment of inflation. In the opening paragraph of its statement, the FOMC states:

Inflation has declined, mainly reflecting lower prices of crude oil and gasoline, and longer-term inflation expectations have remained stable.

What is the basis for the FOMC’s statement that inflation expectations are stable?  Does the FOMC not take seriously the estimate of inflation expectations just published by the Cleveland Fed showing that inflation expectations over a 10-year time horizon are at an all-time low of 1.19% and the expectation for the next 12 months is 0.6%, the lowest since March 2009 when the stock market reached its post-crisis low?  And the FOMC’s April projection for PCE inflation in 2012 was in a range 1.9 to 2.0%; its current projection is now 1.2 to 1.7%.  In contrast to 2008, when the FOMC was in a tizzy about inflation expectations becoming unanchored because of rapidly rising food and energy prices, the FOMC seems remarkably calm and unperturbed about a 0.3% fall in headline inflation in May.

Then in the next paragraph the FOMC makes another — shall we say, puzzling — statement:

The Committee anticipates that inflation over the medium term will run at or below the rate that it judges most consistent with its dual mandate.

So the FOMC admits that inflation is likely to be less than its own inflation target. Let’s be sure that we understand this. The economy is weakening, growth is slowing, unemployment, after nearly four years above 8 percent, is once again rising, and the Fed’s own expectation of the inflation rate for 2012 is well below the FOMC target. And what is the FOMC response?  Steady as you go.

In a news story about the FOMC decision, Marketwatch reporter Steve Goldstein writes:

The Federal Reserve on Wednesday softened its growth and inflation forecasts over the next three years, as the central bank said the unemployment rate will hold above 8% through the end of 2012. The Fed also cut its inflation forecast down aggressively, to between 1.2% and 1.7% this year, as opposed to its forecast in April between 1.9% and 2%. The central bank targets 2% inflation over the medium term, so the reduced inflation forecast is likely to ratchet up expectations of additional central bank easing, possibly as soon as August. The Fed’s forecast for growth this year is down to a range of 1.9% to 2.4%, down from 2.4% to 2.9% in April — and its April 2011 forecast that 2012 growth would range between 3.5% and 4.2%. Also of note, it appears that the two newest voters, Jerome Powell and Jeremy Stein, are among the most dovish; the most recent breakdown of when the right time to raise hikes shows the only change is in 2015, which now has six members in that camp, up from four in April. Powell and Stein were recently sworn in as Fed governors.

So the optimistic take on all this is that the FOMC has set the stage for taking aggressive action at its next meeting. Since bottoming out last week, stock prices recovered, apparently in expectation of easing by the Fed. Today’s announcement is not what the market was hoping for, but there are at least signs that the FOMC will take action soon. In our desperation, we have been reduced to grasping at straws.

Karl Smith, Scott Sumner, and Yichuan Wang have been discussing whether the experience of the 1970s qualifies as “stagflation.” The term stagflation seems to have been coined in the 1973-74 recession, which was characterized by a rising inflation rate and a rising unemployment rate, a paradoxical conjunction of events for which economic theory did not seem to have a ready explanation. Scott observed that inasmuch as average real GDP growth over the decade was a quite respectable 3.2%, applying the term “stagflation” to the decade seems to be misplaced. Karl Smith says that although real GDP growth was fairly strong unemployment rates were much higher after the early 1970s than they had been in the 1960s and even in the lackluster 1950s (a decade of low inflation and low growth). Yichuan Wang weighs in with the observation that high growth in GDP produced almost no measurable effect on real GDP growth even though a simple Phillips Curve or AD/AS framework would suggest that all that extra growth in nominal GDP should have produced some payoff in added real GDP growth.

Here are some further observations on what happened in the 1970s. Inflation expectations began increasing in the late 1960s, so that a very modest tightening of monetary policy in 1969-70 produced a minor recession, but an almost imperceptible reduction in inflation. Nixon, not wanting to run for reelection with a stagnating economy — the memory of running unsuccessfully for President in 1960 during a recession having seared in his consciousness — forced an unwilling Fed to increase money growth rapidly while cynically imposing wage and price controls to keep a lid on inflation. The political strategy was a smashing success, but the stage was set for a ratcheting up of inflation and inflation expectations, though markets were actually slow to anticipate the rapid rise in inflation that followed.

Thus, the early part of the decade fits in well with Scott’s interpretation. Rising aggregate demand produced rising inflation and rising real GDP growth. Unfortunately, wage and price control quickly began to have harmful economic effects, producing shortages and other disruptions in economic activity that may have shaved a few percentage points off real GDP growth over the next few years. More serious was the first big oil-price shock in late 1973 in the wake of the Yom Kippur war, causing a quadrupling of oil prices over a period of a few months as well as horrific gasoline shortages attributable to the effects of remaining price controls on the petroleum sector, controls that, for political reasons, could not be removed even though other price controls had mercifully been allowed to expire. So in 1974, there was a rapid increase in inflation expectations fueled both by a tardy realization of the inflationary implications of the Nixon/Burns monetary policy of 1971-73, and a presumption that increases in oil prices would be accommodated in output prices rather than prices of complementary inputs being forced down. But because of general anti-inflation sentiment, monetary policy was tightened at precisely the moment when aggregate supply was contracting as a result of rising inflation expectations and an exogenous oil-price shock. That meant that real GDP began falling sharply even while output-price inflation was accelerating. It was that temporary conjunction of falling real GDP, rising unemployment, and rising inflation in 1974 that gave rise to the term “stagflation.” After initially focusing on inflation, the newly installed Ford administration quickly pivoted and provided economic stimulus to generate a recovery and the temporary inflationary bulge worked its way through the system. The recovery was robust enough to have enabled Ford to have been re-elected but for Ford’s monumental gaffe in his debate against Jimmy Carter, denying that Poland was under Soviet domination, and for lingering resentment against Ford from his pre-emptive pardon of Richard Nixon for any crimes that he committed during his Presidency.

By the time that Jimmy Carter took office, the US economy was well into a cyclical expansion, but Carter, after replacing Arthur Burns as Fed chairman with the clueless G. William Miller, encouraged Miller to continue a policy of rapid monetary expansion, producing rising inflation in 1977 and 1978. Once again, excess monetary stimulus produced rising inflation and rising inflation expectations just before a second oil-price shock, precipitated by the Iranian Revolution, began in 1979. The combination of rising inflation expectations and rapidly rising oil prices (exacerbated by the continuing controls on petroleum pricing causing renewed shortages of gasoline and other refined products) induced a leftward shift in aggregate supply, causing inflation to rise while output fell. Hence the second episode of stagflation.

So what does this all mean? Well, if one looks at the periods of rapid increases in aggregate demand in which oil price shocks were absent, we observe very high rates of real GDP growth. In the 1960s from the third quarter of 1961 to the third quarter of 1969, real GDP growth averaged 4.8%. Over the same period, the average annual rate of increase in the GDP price deflator was 2.6%. For the 10 quarters from the first quarter of 1971 through the second quarter of 1973, real GDP growth averaged 5.9%, and for 15 quarters from the second quarter of 1975 to the fourth quarter of 1978, real GDP growth averaged 5.1%. The average annual rate of increase in the GDP deflator in the 1971-73 period was 5.2% and in the 1975-78 period, the rate of increase in prices was 6.4%. In the periods of recession or slow growth associated with the oil-price shocks (i.e, 1973-74 and 1979, the rate of increase in the GDP deflator was 9.3% in the former period, and 8.4% in the latter. Thus inflation was higher in recession or slow growth periods than in rapid growth periods. That was stagflation.  Although economic expansions were about as fast in the 1970s as the 1960s, it would not be outlandish to suggest that rapid increases in nominal GDP in the 1970s did produce faster real GDP growth than would have occurred otherwise, though one might also argue that those temporary increases in real GDP growth had a non-trivial downside.

Why was unemployment so much higher in the 1970s than in the 1960s even though the rate of labor force participation was higher? I think that the obvious answer is that there was an influx of women and baby boomers into the work force without much previous work experience. Typically, new entrants into the labor force spend more time searching for employment than workers with previous experience, so it would not be surprising to observe a higher measured unemployment rate in the 1970s than in the 1960s even though jobs were not harder to find for most of the 1970s than they were in the 1960s.