Allan Meltzer wrote a very good essay for the Wall Street Journal on January 27. It dealt with the build-up in the Federal Reserve System’s monetary base as a result of its purchases of government debt, especially Fannie Mae and Freddie Mac debt, in the fall of 2008. Its title and subhead tell the story:
The Fed’s Anti-Inflation Exit Strategy Will Fail
Sooner or later the pressure to lend out excess bank reserves will be unstoppable.
I want to comment on his arguments. I think they deserve wide dissemination.
WHO IS ALLAN MELTZER?
Meltzer is writing a two-volume history of the Federal Reserve. Few people know more about its operations. The first volume is out, and it received good reviews from academics. He is widely respected.
He is an old-timer. He will turn 82 this week. It is quite impressive that he is still writing major books. He served on the Council for Economic Advisors under both Kennedy and Reagan, which is really amazing. He headed the Meltzer Commission in 1998, a committee that examined world trade and monetary policy. He is an Establishment economist, but one in the conservative wing.
He opposed the bailout of AIG in 2008. He initially approved the Treasury’s decision to let Lehman Brothers go bust. He changed his mind a year later. So, he does not share the views of Austrian School economists, who would have favored doing nothing to bail out either of those over-leveraged outfits.
His article is significant because he writes from the perspective of decades of FED-watching. There are few if any FED-watchers with superior credentials, both academic and practical. When he says that FED policies will eventually produce price inflation, we would be wise to give careful consideration to his views. I think it is highly likely that most members of the FED’s Board of Governors have read his article. He has sufficient influence that they would want to see what he thinks they are facing in the months ahead.
PAYING BANKS INTEREST
He began by observing that Chairman Bernanke has explained his exit strategy. I wish Meltzer had offered a link or a reference to this supposed explanation. Bernanke has repeatedly said that the FED will unwind, but I am unaware of any explanation of how, exactly, the FED will accomplish this feat. It is the absence of such an explanation that leads me to believe that there is no such plan, and that the FED is unlikely to deflate the monetary base for long.
Meltzer then refers to the recent decision of the FED to pay interest on bank reserves. He says that Bernanke claims that this will keep banks from lending out money. This policy, Bernanke says, will contain inflation. Meltzer comments: “I don’t believe this will work, and no one else should.”
I have these observations. First, the decision of the FED to pay interest on bank reserves was made on October 22, 2008. That was after the FED had begun the bailouts and its expansion of the monetary base.
Second, this is not a policy of unwinding, i.e., a reversal of the FED’s expansion of its balance sheet. This is a policy of sterilization. The money put on deposit with the FED is not loaned into the economy. This negates the effect of the fractional reserve process. Money not spent into circulation is money that does not multiply.
The monetary base serves as the legal foundation of a future expansion of money. All it will take to begin the expansion is a series of decisions by commercial bankers to pull their banks’ money away from the FED. The act of removing these funds creates the loans. With the exception of reserves held at the FED, every entry on the liability (deposits) side of a bank’s ledger must be offset by assets (loans). Banks cannot withdraw reserves without lending.
Meltzer makes the same point that I have made for several months:
The exit strategy is incomplete. Proponents are guilty of practicing economics without prices. They never say what the interest rate on reserves must be to get banks to hold the approximately $1 trillion of reserves above the minimum they’re legally required to hold. That’s the critical question.
The classic example of this obvious fallacy — no reference to actual interest rates in a discussion of the FED’s policy of paying interest on commercial bank reserves — is a paper written by two staff economists of the Federal Reserve Bank of New York. It appeared last July. Incredibly, the article was accompanied by a disclaimer that its conclusions may not reflect the views of the NY FED.
An economist normally begins with the concept of supply and demand. In monetary affairs, as in all others, the free market clears by means of prices. The supply of loanable funds and the demand for such funds are balanced in a free market by means of a rate of interest.
Meltzer observes that efforts to reduce inflation in the 1970’s failed because they ended prematurely. Unemployment rose in response to higher interest rates. Businesses, unions, Congress, and the Administration complained about rising rates. The same problem — high unemployment — faces the policy-makers today.
Meltzer is speaking of the 1970’s up to, but not including, the last three months of the decade. Paul Volcker and the FED decided to slow the rate of monetary inflation in late 1979. The FED adopted the new policy. Short-term interest rates soared in 1980. A recession hit. Carter lost the election. Then a secondary recession hit in 1981. It lasted into 1982. Later in this article, Meltzer says that Volcker has been the only FED chairman to pay any attention to money growth.
Meltzer asks the obvious question: What rate of interest will the FED have to pay banks for them to keep their money at the FED? He begins with a premise.
Normally, banks’ principal business is lending, and the interest rate they can get on their loans is more important than the interest they might get on their reserves.
The key word here is “normally.” Times are not normal. The FED pays commercial banks the prevailing rate of interest for federal funds, the rate at which banks lend money overnight to other banks that have reached the limit of their legal reserves and must borrow to keeps from exceeding this limit.
Today, the Fed Funds rate is between 0% and 0.25% — essentially nothing. Why? Because most banks are not lending to anyone. They have built up excess reserves to the tune of a trillion dollars. So, banks are not under any pressure to borrow overnight money. The fed funds rate has fallen.
What this means is that the FED is not setting the federal funds rate. Banks are. All of the FED’s press announcements about setting the fed funds rate is nothing but PR flak. There is no rate to set. Banks are not borrowing, because they are not lending. They are holding excess reserves.
Once borrowing resumes, banks will increase loans and expand deposits. The current massive volume of excess reserves will melt into a greater money supply, and later higher inflation.
This is correct. I have been saying this for months. When bankers cease being afraid to lend, they will pull reserves out of the FED and will immediately lend.
When will inflation start? The date is uncertain. But the triggering event will be either a sustained increase in bank lending or a large increase in Fed purchases of government debt. Perhaps both. Either one would trigger a sustained increase in money growth.
All true. The date is uncertain, because bankers are not acting normally. They are squirreling away money at the FED, which sterilizes this money. The FED can and does lend money to the Treasury. It can buy more bonds from Fannie and Freddie. This does not create monetary inflation. The FED adds to its balance sheet, but M1 does not skyrocket. Banks are sterilizing these increases.
THE FED’S TWO GOALS
The FED has a dual mandate, Meltzer says — as do the FED and Congress. It is to keep inflation low and keep unemployment low. It chooses to act on only one of these goals at any time, he says. The result: “. . . it has failed repeatedly to bring low inflation and low unemployment.”
In the 1970’s, the FED’s policies produced the worst of both worlds: high unemployment and high price inflation. Meltzer does not say this, but this unwanted pair of outcomes were what brought Keynesianism into question. This was the decade in which Chicago School monetarism finally got a hearing. (Austrian School economics has yet to gain a hearing among academic economists and policy-makers.)
Volcker’s policies achieved both goals, he says. The country got “15 years of low inflation and low unemployment.” That is one way of looking at it. It is not mine. If we use the inflation calculator of the Bureau of Labor Statistics, we find that the consumer price index rose from 1980 to 1995 by 85%.
He then writes: “But the Fed abandoned its success by keeping interest rates too low after 2003.” Excuse me, but this overlooks everything from 1995 to 2002. Prices rose another 18%.
I agree entirely with Meltzer’s recommendations.
. . . the Fed should announce a policy for preventing inflation that reduces the enormous stock of excess reserves, such as by selling securities. And the Treasury or the Office of Management and Budget should announce a credible policy for reducing deficits. That would help to reduce the uncertainty about future taxes, spending and inflation.
The FED insists that someday, it will unwind. It refuses to say when. It refuses to say how. It refuses to comment on what the results will be.
As for the Treasury, the Administration’s proposed budget for fiscal 2011, announced on February 1, involves a deficit in 2010 of $1.6 trillion, plus another $1.3 trillion in 2011. This announcement came five days after the Congressional Budget Office offered this estimate of the deficit for fiscal 2010: $1.35 trillion. On other words, in just five days, the official estimate rose by $250 billion for the next eight months.
This is not budget deficit reduction.
Meltzer begins his final paragraph with this statement: policies without prices are not credible. This refers to the payment of interest on bank reserves. The policy is not only not credible; the policy is irrelevant. It is not FED policy that is keeping the Fed Funds rate at under 0.25%. It is the overall capital market. Banks are not lending to borrowers, so they are not borrowing overnight reserves from each other.
He concludes with this: “Policy makers should develop and announce credible plans now.”
But how can they? The only credible plan is to cut the monetary base back to 2008 levels or else raise legal reserve requirements as soon as banks start lending. Either policy will bring on a depression.
THE BUSINESS CYCLE
The Austrian theory of the business cycle, announced by Ludwig von Mises in 1912, is that an inflated money supply leads to price distortions in the capital markets. These distortions promote investment in lines of production that will produce losses when the money supply stops growing — not just shrinks, but merely stops growing.
The Federal Reserve has expanded its purchases of debt ever since early September 2008. The increase in excess reserves offset most of this increase. Capital has therefore shifted to government and away from private capital markets. The FED acts on behalf of the Treasury and also Fannie and Freddie.
Because the FED is spending but banks are not lending, there is an increase in the government’s component of the gross domestic product. This will have repercussions next year and thereafter: the expansion of the Federal government’s percentage of the GDP.
If the FED pursues this policy of buying Treasury and F/F debt, the economy will not go into recession until later — maybe 2011. But the FED has insisted that it will cease buying F/F debt after March 31.
It now faces the creation of a secondary recession. The price effects of its expansion of money in 2008 have been muted. This is because of the rise of commercial bank reserves.
Meltzer is not an Austrian School economist. He may believe that the FED can start selling off assets until it winds down the increase of Sept/Oct 2008. It can’t. That would create another Great Depression.
Meltzer sees that the FED’s present policy is not credible. It will produce monetary inflation when banks start lending.
The fact that one of the most judicious students of the FED has gone public with this criticism is significant. Anyone who thinks that the present situation is likely to be maintained had better give up hope of a recovery. The unemployment rate will stay high. The Federal deficit will go higher. The Federal government’s share of GDP will rise. If the banks start lending, the FED will be trapped. It will have to adopt a new policy. It refuses to say what.
It does not know what.