A single goal of long-run price stability should be supplemented with a requirement that the Fed establish and report its strategy for setting the interest rate or the money supply to achieve that goal. If the Fed deviates from its strategy, it should provide a written explanation and testify to Congress. To further limit discretion, restraints on the composition of the Federal Reserve’s portfolio are also appropriate, as called for in the Sound Dollar Act.” John B. Taylor, ‘The Dangers of an Interventionist Fed’, The Wall Street Journal, March 29, 2012
The history of the Federal Reserve System, since its inception in 1913, has been poor from the standpoint of economic stability. During the 1920s, the money supply grew too quickly, promoting the stock market boom of 1929. Excessive tightening in 1929 induced the Great Crash. Bank failures and a contraction of the money supply through much of the 1930s, played a major role in prolonging the Great Depression in the United States.
Between 1960 and 1980, the Fed intervened unpredictably with stop-go changes in money growth, inducing frequent recessions, high unemployment and fluctuating rates of price inflation. The resulting stagflation of the late 1970s encouraged Paul Volcker to usher in an era of rules-based monetary policy designed to squeeze stagflation out of the U.S. economy.
Between 1980 and 2000, the Fed followed monetary rules that led to low unemployment, low inflation, stable interest rates and stronger economic growth. Unfortunately, after the dot-com collapse of 2000, andthe September 11, 2001 attack, the Federal Reserve succumbed to populist pressures as Chairman Alan Greenspan seized the controls with uncontrollable zeal. From 2003 through 2012, the Federal Reserve has behaved in a manic fashion, creating the financial crisis of 2008 and plunging the U.S. economy into a 1930s style recession that shows no sign of ending.
The potential stagflation confronting the United States is of immense proportions. Let me focus on reserve balances credited by the Federal Reserve and deposited in U.S. banks. This is base money,which eventually expands through the money multiplier into the broader M2 money supply (or its equivalent) that, in turn, determines the aggregate level of prices across the economy.
Prior to the 2008 panic, reserve balances held steady at approximately $10 billion. In its own post-2008 panic, including its mindless initial money injections, followed by QE1 and QE2 stimulus injections, the Federal Reserve has pumped up those reserve balances to $1,600 billion – a 16-fold increase.
So far the impact on M2 has been relatively small. But once the recession eases, the scope for expansion in M2 will be dramatic. In the absence of base money contraction, M2 money balances will soar, inducing significant inflation. The economy will be severely disrupted, most likely by inflation, or stagflation, but alternatively by a Fed-induced major recession.
If the Federal Reserve attempts to claw back base money by selling off its enormous portfolio of mortgage securities, long-term interest rates will soar and the housing market will tank. If it sells short term Treasuries, the credit market will dry up and with it, consumer expenditures. If it leaves base money alone, the U.S. will lurch back to double-digit rates of price inflation.
In essence, the Federal Reserve has replaced the entire interbank money market and large segments of other markets with itself. It determines the interest rate without regard for the demand and supply of money. In so doing, it has socialized financial markets, replacing decentralized markets with centralized bureaucratic control. Ben Bernanke has morphed into V.I. Lenin as the autocratic leader of an increasingly socialist country.
Off with his head!