Former Fed vice chairman Alan Blinder warns of the dangers of slowing the central bank's printing presses too early and thereby repeating the mistakes of the mid-1930s. As he explains,
From its bottom in 1933 to 1936, the G.D.P. climbed spectacularly (albeit from a very low base), averaging gains of almost 11 percent a year. But then, both the Fed and the administration of Franklin D. Roosevelt reversed course.
In the summer of 1936, the Fed looked at the large volume of excess reserves piled up in the banking system, concluded that this mountain of liquidity could be fodder for future inflation, and began to withdraw it. This tightening of monetary policy continued into 1937, in a weak economy that was ill-prepared for it.
Blinder is right to warn against ending the liquidity injections too early. But that doesn't mean the party should go on forever. In a sign of the times, however, Blinder's mum on identifying that magic day in the future when the ambitious expansion of the money supply and the Fed's balance sheet should end and the monetary tightening should begin. He's quiet on this point for a very good reason: He doesn't know the date. Nor does anyone else, and therein lies the great challenge confronting the U.S. economy, and one that Blinder avoids discussing in his otherwise salient article on Sunday in the New York Times.
Overlooked or not, there will come a day when the great countercyclical monetary operations of the Fed should cease and desist. That doesn't mean that the efforts to juice inflation will end, at least in a timely manner. To the extent that they don't and they should, the American economy will suffer. Inflation, in sum, lurks in the future, just as it always has and always will. That's the nature of paper money. The issue is one of deciding to control the beast, and it's never too soon to plan ahead.
There's no imminent danger, of course. The seasonally adjusted consumer price index was flat last month and over the past year it's fallen 0.7%. Clearly, there's no pressing reason to raise interest rates at the moment, nor does the futures market expect Fed funds to rise any time soon. But as the Fed's aggressive monetary actions over the past year become deeply embedded in the economic fabric, expecting inflation to remain dormant indefinitely is expecting too much. Indeed, the Fed is effectively spending all its efforts on reviving inflation, and we, for one, think that it'll be successful.
So, too, does the man running the Fed, or so he said when he was a Fed governor expounding on the powers of the printing press when it's controlled by a resolute central bank intent on devaluing the currency, a.k.a., creating inflation. The trick at this juncture is to devalue just a bit so as to perk up the economy without unleashing disagreeably high levels of inflation. Meanwhile, it's hard to overlook the fact that the mountain of debt piling up on the U.S. government's balance sheet would be eased as inflation rises. Paying lenders back in devalued currency has more than a little precedent, and it's hard to believe that the allure will hold no sway in Washington in the years ahead.
In any case, Bernanke is confident about the prospects for elevating the general level of prices, or so he said back in 2002, explaining that "under a paper-money system, a determined government can always generate higher spending and hence positive inflation."
The use of the word "always" sounds rather definitive. The only question is timing. So, yes, Blinder's counsel that the Fed should be mindful of raising interest rates too early and thereby repeating the mistakes of 1936 is germane. But let's remember that his advice addresses only half of the monetary risk that awaits. At some point, the economic trends will shift and waiting too long to raise interest rates will be the primary hazard. We don't know if the turning point will come in a few months or a few years, but we shouldn't delude ourselves that it's never coming.