The Fed's Anti-Inflation Exit Strategy Will Fail

By ALLAN H. MELTZER**

[**Mr. Meltzer is a professor at the Tepper School of Business, Carnegie Mellon University, and the author of "A History of the Federal Reserve" (Chicago, 2003 and 2010).]

Federal Reserve Chairman Ben Bernanke has explained his exit strategy to prevent future inflation. The Fed recently began to pay interest to banks on the reserves they hold in their vaults. Using this new tool, it claims the ability to get banks to keep the money instead of lending it out, thus containing the money supply and inflation.

I don't believe this will work, and no one else should.

The exit strategy is incomplete. Proponents are guilty of practicing economics without prices. They never say what the interest rate on reserves must be to get banks to hold the approximately $1 trillion of reserves above the minimum they're legally required to hold. That's the critical question.

The efforts to reduce inflation during the 1970s failed because they ended prematurely. And they ended prematurely when business, unions, Congress and the administration objected loudly to the rising unemployment accompanying higher interest rates. Today's high current and prospective unemployment rates pose a similar dilemma.

No economist doubts that the Fed can induce banks to hold some more reserves by paying interest. But how much?

Normally, banks' principal business is lending, and the interest rate they can get on their loans is more important than the interest they might get on their reserves. Once borrowing resumes, banks will increase loans and expand deposits. The current massive volume of excess reserves will melt into a greater money supply, and later higher inflation.

When will inflation start? The date is uncertain. But the triggering event will be either a sustained increase in bank lending or a large increase in Fed purchases of government debt. Perhaps both. Either one would trigger a sustained increase in money growth.

With the exception of the early years after Paul Volcker became Fed chairman in 1979, the Fed has paid no attention to money growth. There have always been some Fed bank presidents concerned about too much or too little money growth, but they have not affected decisions. That problem remains.

The Federal Reserve has a well-known dual mandate to prevent both inflation and unemployment. It chooses to act on only one part of its mandate at a time. That cannot be the best way to achieve both targets, and it has failed repeatedly to bring low inflation and low unemployment. For example, the policy implied by the famous Phillips Curve—which says you can trade off higher inflation for lower unemployment—failed in the 1970s. We got rising inflation and higher unemployment.

Mr. Volcker publicly and privately discarded the Phillips Curve in favor of bringing inflation down by high interest rates and better control of the money supply. The result: about 15 years of low inflation and low unemployment. But the Fed abandoned its success by keeping interest rates too low after 2003. And now the Phillips Curve is back in fashion, with strong support from the Fed Board of Governors.

Christina Romer, chairman of the Council of Economic Advisers, reminds us regularly about the Fed and the Treasury's tig ht-money mistakes in 1937 which aborted the recovery, and she warns against repeating these mistakes. The principle drivers behind the recovery in 1934-36 were the veterans' bonus in 1936 and a gold inflow following the 1934 devaluation of the dollar—accomplished by unilaterally raising the gold price. The bonus ended, and the Treasury began to sterilize gold inflows in 1937 by selling securities, while the Fed doubled reserve requirements. Monetary policy shifted from excessive ease to excessive restraint.

Nothing of the kind is called for today. Instead, the Fed should announce a policy for preventing inflation that reduces the enormous stock of excess reserves, such as by selling securities. And the Treasury or the Office of Management and Budget should announce a credible policy for reducing deficits. That would help to reduce the uncertainty about future taxes, spending and inflation.

Policies without prices hide the serious problem posed by excessive debt and reserves, and are not credible. Policy makers should develop and announce credible plans now.