MILTON FRIEDMAN VS. THE FED / THE WALL STREET JOURNAL OP EDITORIAL ( VERY HIGHLY RECOMMENDED READING )

OPINION

NOVEMBER 4, 2010.

Milton Friedman vs. the Fed

The Nobel laureate would never have endorsed increasing inflation to stimulate the economy

By ALLAN H. MELTZER

Would the late Milton Friedman have endorsed the Federal Reserve's plan to make large-scale purchases of long-term Treasury bonds? The idea here is to pump more money into and thus jump-start the economy, reducing unemployment. Some people, including this newspaper's David Wessel in a column last week, believe the great Nobel laureate would favor this inflationary program. I am certain he would not.

Friedman's main message for central banks was to maintain a monetary rule that kept the growth of the money supply constant. In his Newsweek column, "Inflation and Jobs" (Nov. 12, 1979), for example, Friedman emphasized that "unemployment is . . . a side effect of the cure for inflation," so that if a central bank "cured" unemployment by inflating, it "will have unemployment later." In other words, don't try it.


Friedman's Newsweek column for July 28, 1980 ("Improving Monetary Policy") came with the unemployment rate rising past 7%. His proposals for improving policy made no mention of using monetary expansion to reduce unemployment. He proposed rules for stable growth to achieve target "dollar levels of monetary aggregates."


Friedman served on President Reagan's economic policy advisory board. His memos on monetary policy repeat the themes he made familiar to Newsweek readers and others all over the world. There is not a word suggesting that monetary policy should try to raise the inflation rate in order to reduce the unemployment rate.


This is unsurprising, as he had explained many times in the past that any such reduction would be temporary and last only until people caught on to the higher inflation. At that point, they would demand higher wages and interest rates.


Friedman made an exception to his rule about steady-state monetary policy in case of deflation. When prices fell, as they had during the Great Depression or in Japan in the 1990s, he urged the central bank to increase money growth. I served as one of two honorary advisers to the Bank of Japan in the 1990s. With short-term rates close to zero, I gave the same advice, urging the bank several times to buy long-term bonds or foreign exchange to increase money growth until deflation ended.


All this is not relevant now, since there is no sign of deflation in the United States. The Fed's claim that there is a risk of deflation should embarrass it.

In the late 1980s, former Fed Chairman Alan Greenspan encouraged everyone to watch the core deflator for personal consumption expenditure—the PCE deflator. Since then, the Fed has used that measure as its inflation target. Recently, without much publicity, the Fed switched to the consumer price index (CPI). The reason? From 2003 to 2009, the two measures moved together. In 2010, they diverged—and the CPI shows substantially less inflation than the PCE.


Even so, the most recent PCE deflator shows inflation running at around 1.2% annually, about where the Fed says it wants to hold the inflation rate. And it has been between 1.5% and 1.8% for a year. There is no sign of deflation.


The two measures diverged because they give different weights to their components, especially housing prices. The CPI gives almost double the weight to housing prices, especially the rental value of owner-occupied houses. This is not a number that government statisticians sample in the market. They make an estimate. The new long-term bond purchase program puts a lot of weight on a weak foundation.

Paul Volcker and Alan Greenspan restored much of the credibility that the Fed lost in the great inflation of the 1970s. The Fed's plan to increase inflation puts this credibility at risk and is a large step away from the policy that Milton Friedman favored.


Mr. Meltzer is professor of economics at Carnegie Mellon's Tepper School of Business, a visiting scholar at the American Enterprise Institute, and the author of "A History of the Federal Reserve" (University of Chicago Press, 2003 and 2009).


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