The unprecedented and aggressive moves by the Federal Reserve to stem the slide of the US economy have raised concerns about the eventual inflationary consequences of sustained monetary easing. Most recently, Alan Meltzer has addressed this in his op-ed “Inflation Nation” in the New York Times on Monday, May 4, 2009. Meltzer’s views, and those of other inflation hawks, merit consideration. At some point, monetary policy must confront the longer-run effects of current policy. But, like St. Augustine, we hope that policy become virtuous, but not just yet.
Meltzer raises the specter of the runaway inflation of the 1970s, and the painful recession engineered by the Fed, and other nations’ central banks, to wring inflation out of their economies. But the 1970s does not provide the relevant proof text for the present. History does not repeat, of course, but it suggests. And the shadow of history that we should be concerned with today is the 1930s and its depression rather than the Great Inflation of the 1970s.
There were many problems in the 1970s; disco music, leisure suits, and, of course, an insufficient appreciation of the costs of inflation. We’ve learned a lot since then, at least as far as inflation inertia and monetary policy are concerned. Monetary policy cannot fine-tune an economy, and there is an inertia to inflation, not least through its effects on people’s expectations. But it is also worth remembering that the inflation of the late 1970s was built on a foundation that went back to at least the mid-1960s. Consequently, the taming of inflation by the Fed under Paul Volker required the deepest recession that the country had seen since the Great Depression – or, at least the deepest recession up until today, when worldwide economic weakness arose due to financial distress and, importantly, against a backdrop of low inflation.
Meltzer and others concerned about the aggressive policies of the Fed and other central banks cite Friedman’s famous dictum that inflation is always and everywhere be a monetary phenomenon. It does not follow, however, that monetary easing always and everywhere leads inexorably to inflation, not least because the easing itself need not be inexorable.
A more apt lesson from Friedman for the present day comes from his work with Anna Schwartz, the monumental Monetary History of the United States. A central finding of this book is that the contractionary policy by the Federal Reserve (a consequence of a misreading of monetary aggregates), coupled with financial distress, contributed to the severity and duration of the Great Depression. This is the lesson that is most relevant today.
Michael W. Klein
William L. Clayton Professor of International Economic Affairs
Fletcher School, Tufts University
May 4, 2009