Q&A with Allan Meltzer
This internationally recognized expert on the Fed says now is the time for the Federal Reserve to start seriously fighting inflation. Meltzer says the Consumer Price Index is masking rising inflation because of the hefty component that reflects current falling housing prices.
Mortgage Banking
June 2011
By Robert Stowe England
Allan H. Meltzer is the nation’s leading historian of the Federal Reserve System. He is professor of political economy and public policy at the Carnegie Mellon University, Pittsburgh, and one of the nation’s most prominent economists. At a time when all eyes are on the Fed, his view on what the central bank is up to is arguably one of the most valued and trusted.
Meltzer’s most recent magnum opus was a two-volume set published in February 2010, continuing his history of the Federal Reserve System. There was the 696-page A History of the Federal Reserve, Volume 2, Book 1, 1951-1969 and the 616-page A History of the Federal Reserve, Volume 2, Book 2, 1970-1986. Both were met with critical acclaim. These latest books received an Outstanding Academic Titles award last year from Choice magazine, a publication of the Association of College and Research Libraries (ACRL), Chicago.
Richard Sylla, professor of the history of financial institutions and markets at the Stern School of Business at New York University, has described Meltzer’s most recent work as a “magisterial history” from a “first-rate scholar.”
In addition to his most recent work, Meltzer has also written A History of the Federal Reserve, Volume 1, 1913-1951 (2002).
Since 1989, Meltzer has been a visiting scholar at the American Enterprise Institute (AEI), Washington, D.C. He has also been a visiting professor at Harvard University, Cambridge, Massachusetts; the University of Chicago; University of Rochester in Rochester, New York; the Yugoslav Institute for Economic Research, which is now known as the Institute of Economic Policy Sciences in Belgrade, Serbia.; the Institute for Advanced Studies in Vienna Austria; the Getulio Vargas Foundation, Rio de Janeiro; and City University London.
Meltzer served as a member of the Council of Economic Advisers under President Ronald Reagan, from 1988 to 1989. He served as chairman of the International Financial Institutions Advisory Commission of the U.S. Congress for 1999 and 2000. He served as consultant to the Treasury Department, the Federal Reserve Board, The World Bank, foreign governments and central banks.
Meltzer, along with Professor Karl Brunner of the University of Rochester, founded the Shadow Open Market Committee (SOMC) in 1973, of which Meltzer served as chairman until 1999.
The original objective of the committee was to evaluate the policy choices and actions of the Federal Reserve’s Open Market Committee and its discussions and recommendations focused on concerns about inflation. Over the years, the committee has broadened its scope to cover a wide range of macroeconomic policy issues, from monetary and fiscal policy to international trade and tax policy.
In 2003, Meltzer received the Irving Kristol Award from the American Enterprise Institute and the Adam Smith Award from the National Association for Business Economics (NABE), Washington, D.C. He is a distinguished fellow of the American Economic Association, Nashville, Tennessee.
Meltzer received his bachelor’s degree in economics from Duke University, Durham, North Carolina; and a master’s and doctorate in economics from the University of California at Los Angeles (UCLA).
Mortgage Banking caught up with Professor Meltzer recently--after he wrote an op-ed piece for The Wall Street Journal on April 7 titled “The Fed Should Consider a ‘Bad Bank’”--to ask him about his proposal that the Fed spin off $1.069 trillion dollars in longer-term assets into a lockbox.
Q: You are in basic disagreement with Federal Reserve Chairman Ben Bernanke on the outlook for inflation. He thinks inflation is a temporary phenomenon that will go away, and you think otherwise.
A: I have never known a country--and I’ve studied the history for many years--that had high money growth, large budget deficits and a declining exchange rate that ever didn’t have inflation. So, it doesn’t surprise me that I disagree with Mr. Bernanke and some others. The fact is that’s what history tells us.
You don’t have to just read what I write on this subject. There’s a huge book by Rogoff and Reinhart that goes back 200 years [and finds the same correlation between inflation and high money growth, large deficits and a declining exchange rate for a nation’s currency.]
Q: Would that book be This Time Is Different: Eight Centuries of Financial Folly, by Carmen Reinhart and Kenneth Rogoff?
A: Yes, that’s the book.
Q: What are you seeing in terms of signs of inflation?
A: If you look at what businessmen are facing and what consumers are facing, then you know that the Fed is misleading us and misleading themselves by telling us that the [Consumer Price Index (CPI)] is just not showing much inflation.
Q: The CPI absent food and energy has not risen all that much.
A: That’s true, but that’s because 40 percent of the [overall] CPI is what used to be called the rental value of owner-occupied houses. It has a different name now [the owners’ equivalent rent of primary residence], but it’s the same concept. It’s what people would pay to rent the houses that they are in.
Well, people don’t see that number when they go to the grocery store, or what they see when they buy their health insurance. Or, if they are businessmen, when they buy material, they see rising prices. They see them rising all over the world.
So, the question the Fed should be asking itself is: Why is it that prices are rising all over the world but not here?
And the answer is: Well, because we use a very misleading measure. And, if you take the core [rate of inflation]--which excludes energy prices and food prices--you still have nearly 25 percent of the core inflation rate [that] is measuring the rental value of owner-occupied houses. [That] pulls the [core CPI] number down because housing prices are falling. That won’t last for much longer, but it will continue. And when it stops, reported prices will rise much faster.
Q: So, the fact that we have a depressed housing market is giving us a misleading inflation indicator?
A: Yes.
Q: You would think that people at the Federal Reserve, more than anywhere else, would be aware of the fact that depressed housing values are temporarily holding down the reported inflation rate.
A: I think they are aware of it. I don’t doubt that there are people on the staff and people at the Fed who understand exactly what’s going on. For very different reasons, they don’t want to acknowledge it.
Q: Charles Plosser, the president and chief executive officer of the Federal Reserve Bank of Philadelphia, laid out the issues facing the Fed at a meeting of the Shadow Open Market Committee in New York on March 25. He said the Federal Reserve needs to dispose of its excess assets and get to a point where it can use the short-term interest rate for monetary policy.
A: Yes. He and I agreed on that.
Q: He wants to do that with a gradual runoff and sales of the assets held by the Fed, including huge amounts of mortgage-backed securities [MBS]. He would also like to see at the same time a steady, gradual increase in the Federal Funds Rate. You have a very different idea of how to proceed. But first, what do you think of his idea?
A: I would agree with his idea if I thought you could run off the mortgage assets. But there would be screams, bloody screams coming from the home builders, who are a very powerful political interest [group], that you are selling mortgages at a time when the mortgage market is in such terrible straights and the housing business is just so bad. So, I just don’t think that is doable.
That’s why I want to lock [the mortgage assets away] in a lockbox, so those mortgages are not overhanging the market.
Q: In your op-ed in The Wall Street Journal on April 7, you say the mortgage assets would be spun off into a separate entity and would be left there until they mature. Without having to worry about disposing of these assets in the near and midterm, the Fed would be free to focus its monetary policy on price stability.
A: Yes.
Q: So, why is this necessary?
A: The Fed’s problem in a nutshell is always the same. That is, they are twofold. One is they have a dual mandate. [In 1997, Congress required the Fed to promote both “maximum employment” and “stable prices.”]
But they are at the present time and very often much more concerned about avoiding unemployment than they are worrying about inflation. That’s why they rely on these distorted numbers [from the CPI to bolster claims that inflation is low and there is nothing to worry about].
And that second thing is that, as they begin to tighten and sell assets, interest rates are going to rise.
Now, with 9 percent or thereabouts unemployment, how long is it going to take before Congress, the administration, the business community, [and] the public are going to scream? You can’t raise interest rates to 5 percent with so much unemployment. That has always been a problem for the Fed.
That was exactly the problem they faced in the 1970s. It’s exactly the problem they are going to face now. So, what I’m trying to do is to get a lot of the problem out of the way so they don’t have to sell [those assets anytime soon].
They’ve built up over $1 trillion of excess reserves. That’s a lot of excess reserves. You look through the tables to find out when did they ever have anything like that at the Federal Reserve. The answer is never. Never. On any measure, deflated, reduced by GDP [gross domestic product], whatever you want to do. Never. So they have an enormous task to get rid of the excess reserves that they’ve put out there.
Bernanke is insistent on completing the $600 billion more [of quantitative easing], which is adding to that every week. Money growth has begun to rise.
The deficits and debts--anything that is going to happen to them is going to happen in the future, if it happens at all. And the dollar, against weak currencies like the euro and the yen, has been depreciating. If those are not signals that we’re going to have inflation, I have spent 50 years in monetary economics wasting my time.
Q: So, you’re saying that the Federal Reserve is more concerned about unemployment?
A: They’re always more concerned about unemployment.
Q: We’ve been through this before in our lifetimes in the 1970s; that is, focusing more on unemployment than on price stability.
A: Yes, and exactly for this reason. You know, the people in the 1970s at the Fed making monetary policy, they weren’t oblivious to the fact that inflation was building up. They were aware of it. I’ve written a history [of the Federal Reserve], so I can tell you what they said to themselves in their minutes: ‘We have to do something about inflation. We can’t let the inflation get out of whack.’
Then the unemployment rate would creep to 7 percent or 7.5 percent, and all that would be forgotten. And that’s why the Fed is basing [monetary policy] on the idea that as long as the unemployment rate is high, inflation will not happen. That’s because they rely on the Phillips curve.
Q: The Phillips curve, which you reference, is based on the work of the economist William Phillips, who studied the relationship between unemployment and the wage inflation in the United Kingdom from 1861 to 1957. The idea behind the Phillips curve, according to what I’ve read, is that there is a historic inverse relationship between unemployment and the inflation rate, such that the lower the unemployment rate, the higher the inflation rate.
A: But there’s a tremendous amount of research that shows--including research done by very good scholars at the Fed--showing that the Phillips curve was the thing that misled them during the 1970s.
[Former Chairman of the Federal Reserve Paul] Volcker came in, . . . and one of the first things he was asked was, “What are you going to do in your anti-inflation program when the unemployment gets high?” He said that we used to believe there was a tradeoff between the two. But what the record shows is that they rise and fall together.
Q: Which is the opposite of the Phillips curve.
A: Right. So he threw out the Phillips curve and he told them repeatedly, publicly and in the minutes . . . “Look, you are a wonderful staff and you do extremely good work--but your forecasts are worthless.”
Q: Since then, there has been work at the Fed that inflation and unemployment rise and fall together?
A: That work came out in the 1980s.
Q: Under Fed Chairman Paul Volcker?
A: I think it was probably under [Alan] Greenspan.
Q: So, they have that information. It’s not like the 1970s, where people believed in the Phillips curve. Today, people understand that the relationship assumed to exist in the Phillips curve was disproven with the combination of high unemployment and high inflation in the 1970s--so-called stagflation.
A: Everybody knows that.
Q: You do have Charles Plosser at the Fed to make the case that it is wrong to rely on the Phillips curve. He’s there to give his opinion, but apparently many of the rest of the board are not listening to him?
A: Right. It’s not just Charles. There’s, after all, Tom Hoenig [president of the Federal Reserve Bank of Kansas City], who has dissented eight times, which I think is the record of anyone dissenting in a year at the Fed. The presidents of [the Federal Reserve Banks of] Richmond [Jeffrey Lacker] and Dallas [Richard Fisher] and to some extent now St. Louis [James Bullard], are coming pretty close to agreeing with what I say. They think there’s a big problem of inflation. The president of the Dallas [Federal Reserve bank] certainly is on that side. He warns about it all the time in public statements.
Q: What exactly is it that the Fed needs to focus on instead of focusing so much on unemployment?
A: They need to focus on inflation--or future inflation. One of things that the Fed does that is badly in need of change is that it focuses--if you read their minutes, as I have done, from the 1920s all the way up to the 1980s--they focus very much on what is happening now. They don’t have much control over what happens in the next few months. They have control over what happens over the next two years. But they don’t pay too much attention to that. I mean, you can read what they say in their minutes to each other. But rarely will you find a statement that says, “Look, if we continue on this path, we are going to end up with such and such.”
Q: Why is that?
A: There is political pressure on them from Congress, from the administration, I think, from the market. [T]he market people are a terrible source of this [pressure]. The Fed responds very much to what Wall Street pushes on them.
Q: But the markets seem to be saying there is inflation.
A: Well, some of them do and some of them don’t.
Q: There has been a lot of talk of inflation by a lot of commentators, at least in commodities.
A: Oh, sure. The Fed’s attitude is that the rise, in especially oil and food prices, is temporary and won’t continue.
Q: That was like the same view that prevailed in the 1970s. It’s like déjà vu here.
A: It is déjà vu, except it’s déjà vu from a much worse position.
Q: Let’s talk about your idea of locking up the Fed’s excess assets. How would that work?
A: The Fed would move its assets, its 10-year mortgages, into the lockbox and say, “We are not going to sell these. We are going to wait until they run off 10 years from now or more.” And they would move over as a liability $1 trillion or more of excess reserves.
Q: Does the Fed have the legal authority to do this?
A: I’m not certain about that, but I’m sure they could attain it. My reading of the history of the Fed is that they will have a lawyer find a legal authority for doing whatever it is they want to do.
Q: As I understand it, this includes longer-term Treasuries and mortgage assets?
A: Well, there are some Treasuries, but they are a small part of it. It’s mostly mortgage assets.
Q: They had $1.25 trillion in mortgage assets at one point and as of April still had $937 billion, and that is still, as we have discussed, a very weak market. So, this would also have the benefit of not dumping mortgage assets into a weak housing market.
A: That’s correct.
Q: What sort of balance sheet would we see at the Fed after this transfer?
A: They would be down to a level of excess reserves [that] would permit them to operate in a market like a normal central bank.
Q: More to the historical level of assets.
A: Relative to size of the economy.
Q: Your idea is different from Charles Plosser’s in that his would take 18 months, but you would immediately have the tools to fight inflation?
A: Yes.
Q: What do you think needs to be done, once you transfer the assets?
A: You would start raising the interest rate. The real interest rate is negative, substantially negative. That’s the rate that counts for business. So, we should start raising the Federal Funds Rate. Begin with 1 percent and move on from there.
Q: Do you have a suggested target rate to hit in 18 months?
A: No, I don’t.
Q: What kind of response have you gotten to your idea?
A: As usual, I got a lot of support and a certain amount of criticism.
The critics are mostly people who say, “Meltzer doesn’t know what he’s looking at--there really isn’t any inflation.” These are people whose heads are in the sand.
Q: It’s hard to reach people like that. I guess we’ll have to wait and see the actual inflation that occurs.
A: That will be too late. Once it’s here, the temper in the market will be [that] Bernanke misled us. They’ve done a terrible thing. [You’ll hear] the usual kind of screaming you get from the day traders and Wall Street.
Q: It seems like then we are on a course to repeat the 1970s, and we can’t seem to do anything about it.
A: We can do something about it. We just don’t seem to be willing to do something about it.
MB
Robert Stowe England is a freelance writer based in Arlington, Virginia. He can be reached at
Copyright © 2011 by Mortgage Banking Magazine. All rights reserved. Reprinted with permission.
