Wednesday, October 13, 2010

Please! Professor Meltzer!

Allan Meltzer has criticized the Fed's proposal for a new round of quantitative easing.

He claimed that the Great Inflation was caused by the Fed choosing to target higher inflation in order to reduce unemployment.
Increasing inflation to reduce unemployment initiated the Great Inflation of the 1960s and 1970s. Milton Friedman pointed out in 1968 why any gain in employment would be temporary: It would last only so long as people underestimated the rate of inflation. Friedman's analysis is now a standard teaching of economics. Surely Fed economists understand this.

That isn't the way I understand the history. On the contrary, the Fed targeted short term interest rates in order to lower unemployment, or at least to prevent it from rising, and claimed that inflation was caused by "cost push" factors. So, for example, the Fed would observe rising inflation, and refrain from raising short term interest rates because unemployment was too high, or at least, wasn't too low.

The implicit model was that the Fed controls the short term nominal interest rate, which impacts real expenditure. Real expenditure impacts real output, employment, and unemployment. Inflation depends on "cost push" factors. If the Fed's target for the unemployment rate is too low, then this "model" can easily result in progressively worsening inflation--something like the Great Inflation.

I am no fan of the "new Keynesian" approach, but the model today would be that higher expected inflation reduces real interest rates on short term, safe assets that already have nominal yields near zero. This directly raises real expenditure, but also creates a shift towards riskier and longer term securities that have higher real yields, lowering those real yields as well. This also results in greater real expenditures. The higher real expenditures raises real output and employment and lowers the unemployment rate. Inflation rises consistent with the higher expectations of inflation.

While this approach does imply a higher inflation rate, and perhaps it won't work to reduce unemployment, there seems to be little danger of a return to the Great Inflation of progressively worsening inflation. If inflation rises "too much" then the new Keynesian approach calls for an increase in short term, low risk, nominal interest rates by more than the increase in expected inflation.

While the Fed and the new Keynesians remain wedded to interest rate targets, Milton Friedman won the war about the Fed's responsibility for inflation. Treating a target for unemployment as a goal of monetary policy (say, keep unemployment at 4%,) has next to no support.

Some of Meltzer's other comments are even more disappointing. He claims that there is plenty of liquidity. However, the proper standard isn't how much was apparently needed in the past, but rather relative to the current demand to hold liquid assets. With money expenditures well below their trend from the Great Moderation, it is apparent that there isn't enough to meet the demand.

Surely Meltzer hasn't adopted the "market clearing" approach which implies that the current level of prices and wages must be at the level that keeps the real quantity of money equal to the real demand for money, and simultaneously, the flow of real expenditures equal to the productive capacity of the economy. Sure, there is always enough liquidity to meet the demand if that is true, but how realistic is that?

Similarly, real interest rates, especially on short and safe assets, are very low by historical standards, but apparently they are not low enough to coordinate saving and investment. Perhaps the Obama administrations policy of green jobs, health care reform, and making the rich pay their "fair" share of taxes to fund out of control spending depresses investment. But real interest rates should coordinate saving and investment given expectations of future profitability, not only if business people feel comfortable with the current political leadership.

I am very puzzled by Meltzer's concern that the Fed cannot reduce the excess reserves in the banking system when the demand for credit recovers. The Fed gets weekly data on bank deposits and loans. While the Fed would probably need to raise its target for the Federal Funds rate in the face of growing loan demand, the quantity of credit offered by the banking system doesn't have to shrink, but could even grow. The notion that they must passively allow the quantity of money to expand enough so that all of the excess reserves in the banking system today become required, or perhaps, drained off into currency holdings, is absurd.

Of course, to the degree the Fed holds bad securities (say, mortgage backed securities that are claims to lots of mortgages in default,) the Fed might run into problems. Further, their failed new Keynesian approach of dealing with the zero bound on short term and safe assets by promising to keep interest rates low for a good long time, is a bit of a problem.

Meltzer really does seem to remain committed to some kind of quantity of money rule. And if the demand to hold money rises, so that a quantity of money rule results in monetary disequilibrium, and reduced money expenditures, then the problem is the economy. They shouldn't demand so much money.

No! The quantity of money should adjust to accommodate the demand to hold money, with a nominal anchor of a stable growth path for money expenditures. With such a policy, real output, employment, unemployment, the price level, and inflation all depend on market forces. Still, there is no way that such a policy would result in another Great Inflation. Well, unless the the target for the growth path of money expenditures is in double digits.

Like Meltzer, I am a critic of the Fed. But I think QE2 (another round of quantitative easing) is appropriate because money expenditures are far below any reasonable trend.

I agree with Meltzer that a higher target for the inflation rate is a mistake, but not because I think the current target of 2 percent is optimal. On the contrary, inflation targeting should be replaced by a target for the growth path of money expenditures consistent with zero inflation in the long run.

And what I would like to see from Meltzer is evidence that he remembers the distinction between money and credit and doesn't consider the Federal Funds rate, or any other interest rate, as providing any clear signal of the stance of monetary policy.


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