OCTOBER 8, 2010.
The 'Limited Inflationists'
Fed Chairman Ben Bernanke and his QE Street Band
Federal Reserve Chairman Ben Bernanke is a student of monetary history, so perhaps he remembers Sumner Slichter. In the 1950s, the Harvard economist made his reputation as the leader of an intellectual band that Time magazine dubbed the "limited inflationists"—the idea that some inflation was good for an economy, and that the Fed should encourage a gradual rise in prices.
In a hearing on Capitol Hill, his views drew a famous rebuke from Fed Chairman William McChesney Martin, but Slichter's ideas gained currency in the 1950s and 1960s and eventually laid the groundwork for the not-so-gradual inflation of the 1970s.
Slichter died in 1959, but he is staging a rebirth at none other than Martin's former home, the Federal Reserve. A galaxy of Fed officials has fanned out to argue for another round of "quantitative easing," or a further expansion of the Fed balance sheet to boost the economy. The "limited inflationists" are once again at America's monetary helm, promising happier days from rising prices while downplaying the costs and risks.
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In the first QE go-around in spring 2009, financial panic was still in the air and the Fed's justification was to save us from Depression. Today, the panic is over and an economic recovery is underway. So the Fed's new justification is that growth is still too slow, unemployment is still too high and prices aren't rising fast enough.
The Fed's Open Market Committee hinted at the inflation-is-too-low argument in its statement after its September meeting, noting that "Measures of underlying inflation are currently at levels somewhat below those the Committee judges most consistent, over the longer run, with its mandate to promote maximum employment and price stability."
Last week, Chicago Fed President Charles Evans went further and put a specific number on it—inflation below 2% a year is undesirable. He was joined in his case for easier money by the New York and Boston Fed Presidents, among others. The clear message is that a Fed majority has come down on the side of QE2, and markets have concluded that the central bank will return as early as November to buying hundreds of billions of dollars of assets to ensure what Mr. Evans called a need for "negative interest rates." Sumner Slichter rides again.
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We hope this experiment in re-inflating the economy works better this time, but mark us down as skeptical. There is no such thing as free money, and a second round of QE carries enormous risks for what looks to us like far too little benefit.
The theory of QE2 is that by buying Treasurys and other assets, the Fed help drive long-term interest rates down even lower than they are already. This in turn will spur more private lending and borrowing and kick-start faster growth. But we're told the Fed's own internal models suggest that a purchase of $500 billion in Treasurys would only reduce the 10-year bond by something like 15 basis points. (The 10-year yield is now 2.38%.) This in turn would increase GDP by 0.2% a year and cut the jobless rate by 0.2%. That's not much bang for a lot of bucks.
The case for QE2 assumes that the problem with the economy is merely a lack of money. But trillions of dollars are already sitting unused on bank and corporate balance sheets. The real problem isn't lack of capital but a capital strike, as businesses refuse to take risks or hire new workers thanks to uncertainty over government policy, including higher taxes and regulatory burdens. More Fed easing in this environment risks "pushing on a string," adding money to little economic effect.
Meanwhile, the costs of QE2 would be real and significant. With Congress spending as much as ever, the Fed would appear to be financing a spendthrift government almost on a dollar-for-dollar basis. This would make it even harder, and take even longer, for the Fed to extricate itself from the market for Treasurys and mortgage securities once it decided to do so. And by firing all of its ammo now amid a recovery, what would the Fed have left if we get another financial panic?
By keeping interest rates artificially low, the Fed is also contributing to a misallocation of capital and perhaps new asset bubbles. Messrs. Bernanke and Evans say they see no signs of inflation, as measured by the lagging indicator of the consumer price index.
But investors are having no trouble bidding up the price of commodities, including oil and gold. A rising price of oil will have its own negative impact on growth, as we know from the experience of $147 oil in mid-2008. A commodity price spike might well erase any benefit from the expected decline of 15 basis points in long-term bond yields.
As the protector of the world's reserve currency, the Fed also risks more global monetary disruption. The mere anticipation of QE2 has already caused Japan to pursue its own purchases of exotic assets, while Britain may do the same, as they and other countries try to avoid sharp rises in their currencies against the dollar. The European Central Bank may well have to follow, as the entire world adopts the "limited inflation" philosophy. In such a world, it's hardly surprising that gold has climbed in price against all major fiat currencies as a remaining store of value.
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With such a cost-benefit calculus, why is the Bernanke Fed still plowing ahead with QE2? Our worry is that the motivation is mainly political.
The Board of Governors and Open Market Committee are now dominated by President Obama's appointees and intellectual allies. They know that their great experiment in spending stimulus has failed to spur a durable expansion, and so they are turning in unquiet desperation to the only tool they have left—monetary easing—to rescue their policy. For them, the risks of slow growth and a 9% jobless rate going into 2012 are worse than the danger of asset bubbles or a new burst of inflation.
Which brings us back to Sumner Slichter and the limited inflationists. Amid the political and media interest in their ideas, Fed Chairman Martin appeared before the Senate Finance Committee. "There is no validity whatever in the idea that any inflation, once accepted, can be confined to moderate proportions," the father of the modern Fed thundered, in a warning that would be vindicated after his retirement in 1970. That's a warning as well for the QE Street Band.
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