Last Tuesday Federal Reserve chairman Ben Bernanke wrote in The Wall Street Journal how, at an appropriate time, the Fed would move to remove the excess liquidity the Fed has pumped into the economy over the last 12-18 months, thus avoiding the inflation surge that some fear.
The problem, however, is as The Wall Street Journal said in an editorial the next day:
"Federal Reserve Chairman Ben Bernanke took his ‘exit strategy’ on the road yesterday, promising that he knows how to withdraw excess liquidity from the financial system in time to avoid a new inflation or another asset bubble. We’re glad to hear it, but then few have doubted that the Fed knows how to exit. The issue is whether he and his fellow Governors have the nerve to do it."
The editorial continued:
"Mr. Bernanke was far less reassuring on the more potent questions of whether and when the Fed will reduce its balance sheet. In particular, the Fed chief reiterated that it’s too early to start tightening and that the Fed will keep its current policy of near-zero interest rates for ‘an extended period.’ So how long is extended? Mr. Bernanke didn’t say, and we are all supposed to assume that he’ll know the right moment when he sees it.
As readers of these columns know, we’ve been here before—specifically, in late 2003 when Mr. Bernanke was a Governor at Alan Greenspan’s Fed. … Mr. Bernanke argued at the time that the Fed needed to keep the fed funds rate at 1% for an ‘extended period’ in order to reduce unemployment. Thus began the commodity and credit bubbles that brought us to our current pass. …
This time the Fed’s political and policy dilemmas will be far more acute. The Fed’s current policy is the easiest in its history and continues even as the financial panic has subsided and the big banks are again making money. On the other hand, the jobless rate is 9.5% and likely to climb further even once the recovery begins. …
Congress and the White House want the Fed to stay easy as long as unemployment stays high. But if the Fed does so, it will run the risk of acting too late, well after inflation expectations have begun to build."
And then, in the news sections of Thursday’s Wall Street Journal, came this report:
"The job market is doing even worse than the overall economy, prompting concern inside and outside the government that deeper-than-expected joblessness could persist once the recession ends.
Breaking from historical patterns, the unemployment rate – currently at 9.5% – is one to 1.5 percentage points higher than would be expected under one economic rule of thumb, says Lawrence Summers, President Obama’s top economic adviser. …
Though today’s disparity between growth and jobs is especially stark, a jobless recovery wouldn’t be new: The past two recessions were marked by firms reluctant to resume hiring right away after demand recovered."
And therein lies the problem: Unemployment is a lagging indicator of economic activity, and based on what happened in the last two recoveries (see above and remember all those Democratic complaints about President Bush’s "jobless recovery"), it may lag even more now than it has in the past. If the Fed is "encouraged" by Congress and the President to keep interest rates low because of high unemployment, i.e., if the Fed does not start taking the excess liquidity out of the system until unemployment drops significantly, it will be too late.
Currently, the recession and a decrease in the velocity of money have kept a lid on inflation. As the economy picks up, and the velocity of money returns to a more normal level, the amount of money in the economy will increase dramatically. If we hope to avoid inflation, the Federal Reserve needs to take liquidity out of the system, i.e., raise interest rates, before unemployment drops. If it does that, our politicians (especially the Democratic leadership in Washington) will scream. But if the Fed does not do that, we will wind up with the classic cause of inflation: too much money chasing too few goods.*
In the early 1980s, one of the main reasons Paul Volcker and the Federal Reserve were able to adopt and maintain the tight monetary policies necessary to break the back of inflation was because Ronald Reagan supported them. It wasn’t politically popular, and the Republicans lost a lot of seats in the 1982 elections, but President Reagan understood that what Mr. Volcker was doing needed to be done. The combination of Volcker’s actions and Reagan’s support laid the basis for the two decades of low-inflation prosperity that followed.
Unless we have leaders like that in Washington today, we can look forward to inflation in our future.
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* The "amount" of money in the economy over a period of time is, in effect, the product of the quantity of money multiplied by the speed at which the money moves around (i.e., the "velocity" of the money). Recently, even as the Fed has pumped more money into the economy, the "amount" of money has not gone up all that much (if at all) because the speed at which the money is moving around has decreased. When the economy picks up, however, the speed (or velocity) will pick up, too. If liquidity is not removed from the system before that happens, the product of the quantity of money times its velocity will increase considerably more than any increase in the quantity of goods and service. When that happens, you have inflation.
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