Federal Reserve Chairman Ben S. Bernanke is siding with John Maynard Keynes against Milton Friedman by flooding the financial system with money.
If history is any guide, says Allan Meltzer, the effort will end in tears. Inflation “will get higher than it was in the 1970s,” says Meltzer, the Fed historian and professor of political economy at Carnegie Mellon University in Pittsburgh. At the end of that decade, consumer prices rose at a year-over-year rate of 13.3 percent.
Bernanke’s gamble that the highest jobless rate in 25 years and the most idle factory capacity on record will hold down inflation is straight out of the late British economist Keynes. Should late Nobel-prize-winner Friedman’s dictum that “inflation is always and everywhere a monetary phenomenon” prove right, the $1 trillion or more in liquidity Bernanke has pumped into the financial system by expanding the Fed’s balance sheet may leave him to cope with surging consumer prices.
So far, investors and economic data both back up the Bernanke-Keynes view. The market in Treasury Inflation-Protected Securities as of April 6 indicated long-term inflation expectations of 2.5 percent, below the 2.8 percent average inflation rate of the past 10 years.
Still, the 2.5 percent expectation represents an increase from 2.1 percent at the end of last year. And Meltzer, 81, who has written an 800-page history of the Fed’s first 38 years and is now working on volume two, isn’t alone in seeing a return of sky-high inflation as a result of Bernanke’s policies.
John Brynjolfsson, chief investment officer at hedge fund Armored Wolf in Aliso Viejo, Calif., says the Fed is still in the early stages of its effort to pump up the economy.
“We’ve got at least nine innings of reflation ahead of us, ultimately ending with probably double-digit inflation,” he said in a Bloomberg Television interview on April 6.
Investors are starting to protect themselves from the risk of faster price increases by buying TIPS, pushing up the return on the securities to 6.1 percent in March, the best performance since the U.S. government introduced them in 1997, according to Merrill Lynch & Co. index data.
Behind investors’ caution: a ballooning Fed balance sheet that has climbed $1.2 trillion in the past year to $2.1 trillion and expanded the nation’s money supply. It is poised to increase even further after last month’s Fed decision to buy an additional $1.15 trillion worth of assets, including $300 billion in Treasury securities.
M2, a broad measure of the money supply that includes checking accounts and money-market mutual funds, rose in the last six months at an annual rate of 14 percent. That compares with an average 6.3 percent during the last decade.
Meltzer says political pressure will prevent Bernanke, 55, and fellow policy makers from withdrawing liquidity quickly enough as the economy recovers. That’s similar to the pattern that occurred back in the 1970s, he says. Then-Chairman Arthur Burns allowed excessive money-supply growth because he was unable or unwilling to resist pressure from President Richard Nixon’s White House to hold down unemployment, leading to the “great inflation” of that era, he says.