Inflation is ultimately and always a monetary phenomenon. The Federal Reserve’s extraordinary actions during the recent crisis now require executing a difficult exit strategy without short-circuiting the recovery and most especially without letting inflation get out of control. Comments by Fed officials beginning with Chairman Ben Bernanke suggest they are committed to containing inflation and the Fed appears to have the tools to do so. But will they use those tools wisely? A specific, consistent thread in Bernanke’s comments suggest the Fed will yet let inflation get out of the bag despite the best intentions and tools.
The substance of the inflation threat is in two parts. The first is the trillion dollar mountain of bank excess reserves the Fed has created and that are now idling on the Fed’s balance sheet. If banks choose to begin tapping these reserves in large quantities, drawing them into the credit creation process, then the economy may get a welcome initial pop, soon to be followed by rapid resurgent inflation. The Fed has new tools, especially its ability to pay interest on excess reserves that should allow it to modulate the outflow of excess reserves.
Central to the Fed’s response in the recent crisis was the reduction of the Federal funds rate essentially to zero. At some point, the Fed must begin raising the funds rate toward a more normal, more neutral level. If the Fed is late in raising the funds rate, as it was late coming out of the last recession and as it was late in cutting the funds rate at the onset of the crisis, then even if it controls the outflow of excess reserves another spate of asset price bubbles is possible and unacceptably high inflation becomes likely.
The Fed has substantial credibility when it signals its intent to fight inflation. However, danger lurks in the Chairman’s words. The root of the danger is the pervasive belief that economic weakness in the form of substantial excess capacity and high unemployment will persistently dampen inflationary pressures. Whatever effects excess capacity has on inflation pressures in the short run, those pressures disappear before long (PDF is in draft form)
This recalls an earlier episode in the late 1960s and 1970s when economists believed they could buy a reduction in the unemployment rate at the cost of a modest increase in inflation. It turned out this fleeting bargain quickly produced stagflation – high unemployment and high inflation. The current thinking is just the converse – the belief that high unemployment buys low inflation. It does not work this way, either.
One year and a week after Congress enacted legislation creating the $700 billion “Troubled Asset Relief Program,” the Treasury Department next week is expected to launch its first initiative to buy, well, troubled assets. Odd as it may be, in the year since its creation TARP has been used for just about everything but the original purpose of buying troubled, or “toxic,” mortgages and other securities from financial institutions.
Now comes word that a long-planned Treasury program to acquire assets will be ready to begin. That’s bad news. Not only is the program flawed, but the emergency that spawned it is over. TARP should be ended, not further implemented.
The new program, known as the public-private investment program (”PPIP”), was first announced this March. Much scaled down from its original version, it provides for the purchase of troubled securities by pre-approved money management funds, using private capital matched by TARP funds and non-recourse loans. The net result: taxpayers and private investors would share equally any profits from purchasing troubled securities, but taxpayers would bear more of the downside risk of loss.
The program was questionable from the beginning (as discussed here), and is even more so now. TARP was enacted as an emergency measure to forestall a breakdown of the financial system. Today, that system, while still weak, is not near to breaking down. Even if it were, the amounts involved in this new program are too small to make a significant difference (about $12 billion is available so far), but large enough to skew markets and enrich a few people smart enough to take advantage of its provisions.
Instead of focusing on new and improved TARP programs, the Obama Administration should be working to end it. Under current law, authority to commit funds from the $700 billion TARP kitty expires at the end of this year, unless Treasury Secretary extends it for another year. Secretary Geithner should make it clear that he will not do so.
But the TARP exit strategy should not end there. The Administration also needs to set out clear plans for the expeditiously return of the federal government’s outstanding investments. This should include firm, and short, deadlines for the sale of enterprises such as General Motors, which have been fully or partially nationalized. And if the Administration does not act, Congress should not hesitate to step in. Legislation to set deadlines for denationalization has already been introduced by Sen. John Thune of South Dakota.
The crisis aspects of the economic downturn and the related concern over troubled assets that led to TARP are long past. Whatever its initial benefits, if any, the program has left a legacy of economic distortion, dependence and debt that will take years to heal. And yet another variation on TARP is set to begin. The Administration — or Congress — should instead end TARP, and establish a clear plan for the return of the taxpayers’ investment as fully and quickly as possible.