Politics, Wall Street, and the Fed

In this op-ed piece in today's Wall Street Journal, Allan Meltzer adds to the growing scrutiny of Ben Bernanke and crew at the Federal Reserve since last summer when the wheels started coming off of both the U.S. economy and the global financial system, after which the Fed started slashing interest rates.

According to Wikipedia, Dr. Meltzer is "the author of dozens of academic papers and books on monetary policy and the Federal Reserve Bank, and is considered one of the world's foremost experts on the development and applications of monetary policy", though, he doesn't really photograph well.

He is said to be working on Volume II of his "History of the Federal Reserve Bank", covering the period from 1951 to the present. He probably knows what he's talking about.

That '70s Show
By ALLAN H. MELTZER

Is the Federal Reserve an independent monetary authority or a handmaiden beholden to political and market players? Has it reverted to its mistaken behavior in the 1970s? Recent actions and public commitments, including Fed Chairman Ben Bernanke's testimony to Congress yesterday -- where he warned of a steeper decline and suggested that more rate cuts lie ahead -- leave little doubt on both counts.

An independent central bank is supposed to maintain the value of the currency and prevent inflation. In the 1970s and again now, Federal Reserve officials repeatedly promised themselves and each other that they would lower inflation. But as soon as the unemployment rate ticked up a bit, the promises were forgotten.

People soon recognized that avoiding possible recession overwhelmed any concern about inflation. Many concluded that inflation would increase over time and that the Fed would do little more than talk. Prices and wages fell very little in recessions. The result was inflation and stagnant growth: stagflation.

It's beginning to happen again. Unlike the response of wages and prices in the low inflation 1990s, expectations of rising inflation now delay or stop price and wage adjustment, inhibiting growth.

One lesson of the inflationary 1970s: A country that will not accept the possibility of a small recession will end up having a big one when the politicians at last respond to the public's complaints about inflation. Instead of paying the relatively small cost of a possible recession, the public pays the much larger cost of sustained inflation and a deeper recession. And enduring the deeper recession is the only way to convince the public that the Fed has at last decided to slow inflation.

It looks like we're going to need another fix to how the Bureau of Labor Statistics calculates inflation, as was done in the 1980s and 1990s. For a few years now various Fed economists, including Ben Bernanke, have indicated that "inflation" is overstated by about one percent.

That seems to be the only reasonable approach to reducing inflation during an election year when the economy is stalling and the unemployment rate is rising.