By Randall Holcombe • Tuesday July 21, 2009 11:40 AM PDT •
Federal Reserve Chairman Ben Bernanke told Congress he has an exit strategy to rein in excess growth in the monetary base when the time comes. The problem is, any action that would reduce the bloated monetary base would do so by increasing interest rates, and Bernanke has also said he will keep interest rates low to support the recovery.
The recovery is likely to be slow, for one reason because the “stimulus package” imposes so much government spending on the economy, which must be supported by private sector productivity, and because of the burden of the trillion dollar deficits President Obama projects for as far out as they are projected. Ironically, the “stimulus” measures we’ve undertaken will slow the recovery, not help it. Thus, Bernanke will be reluctant to raise interest rates as an anti-inflationary measure until we actually see rising prices.
By that time, it will be too late to prevent inflation. As Milton Friedman said, with monetary policy there are long and variable lags. Once inflation starts to show up, it will continue for a few years even if Bernanke starts anti-inflationary moves (which will come with higher interest rates) immediately. If the economy enters a robust recovery, higher interest rates won’t be a problem. If the recovery is sluggish, Bernanke is likely to hold off on inflation to support the economy.
How high would inflation have to get before Bernanke saw it as a problem? Three percent? Four percent? If he waited that long to deal with it, we’d have inflation several percentage points higher than that before inflation actually moderated.
Will Bernanke be skillful enough, or lucky enough, to work a balancing strategy between supporting a fragile economy and keeping inflation in check? I’m guessing no, because there is too much of a temptation to hold off on the inflation front until confronted by the actual evidence of rising prices, and by then there will be several more years of rising inflation before it starts to fall again.
This is just what happened in the 1970s. We knew how to stop inflation, but we also knew it would be painful (that pain was the 1982 recession), so we put it off until inflation went into double digits. Bernanke is a smart guy, and he knows monetary history—including the monetary history of the 1970s—very well. So what I’m saying would not be news to him. He just thinks he’ll be able to balance the twin goals of supporting a weak economy and keeping inflation in check so that inflation doesn’t reappear. I’m not confident he can do this.
I’m guessing that in five years we’ll be looking at inflation in the 5 to 10 percent range, but if it gets as high as 15 percent I wouldn’t be surprised. Yes, once it gets over five percent we’ll be concerned and want to do something about it, but by then it may be too late to stop it from getting to 10 percent. And if we’re still concerned about the soft economy when inflation gets to 7-8 percent, an eventual rate of 15 percent would look more likely.
Bernanke says he has an exit strategy, and I hope he’s able to pull it off more successfully than when Nixon told us he had an exit strategy for the Vietnam war. I’m hopeful, but not optimistic.