Should Bernanke Cool It?

Most of the news of late has been a lot cheerier than the reports that descended on us only a month ago. The interbank lending rate is below 1 percent, well down from the 6 percent peak it reached when banks were so unsure of the ability of their counterparties to survive that they refused to lend, even overnight. The housing market is showing signs of life, with inventories of unsold houses beginning to get sopped up in some of the hardest-hit cities. Commodity prices are on the upswing, suggesting greater demand for materials used by manufacturers. Consumers are striking a more durable balance between spending and saving after a period of keeping their purses tightly zipped. Inventories of goods have dropped to levels that will soon require shop keepers and others to re-stock their shelves. Consumer panic is giving way to a more confident outlook: retail sales in April recorded their largest gain since August of last year, with Wal-Mart leading the pack. China’s economy has responded to a stimulus package and is adding to worldwide demand for many products.

Only the jobs market has yet to flash signs of robust recovery–the unemployment rate jumped from 8.5 percent in March to 8.9 percent in April (up from 5 percent only twelve months ago), and would have been higher still had the government not hired 66,000 census takers. But the number of jobs lost in April was the lowest since October, and employment is always the last indicator to recover from a downturn. Moreover, a variety of Treasury measures, and a good part of the stimulus package, are about to add a bit of oomph to the nascent recovery.

This generally better news is complicating the lives of Ben Bernanke and his colleagues on the board of the Federal Reserve Bank. Until now, they had an unambiguous goal: do everything necessary to avoid having a credit crunch produce a collapse of the financial system, and pump cash into the economy to prime the pump, as we were wont to say in the 1930s. By most standards, Bernanke did what he had to do, and did it very well. Not only did he drive short-term interest rates close to zero, putting downward pressure on other interest rates–most notably mortgage rates. He also seemed to devise one gambit after another to prop up the economy, short of, but not very short of dropping dollars from a helicopter and demonstrating that his sobriquet, Helicopter Ben, was well earned.

Now, just as a few rays of sunshine are peeking through the gloom, all of that cash has driven the inflation rate–measured by the most reliable indicator, the GDP deflator–to almost 3 percent, “a sure sign of inflation,” according to Allan Meltzer, an economics professor at Carnegie Mellon University and the author of the massive and authoritative “History of the Federal Reserve.” Barack Obama’s “enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation are harbingers of inflation”, says Meltzer.

And not just your garden-variety inflation. Inflation so rapid that the value of the dollar will plummet, and China and other countries that have been willing to accept it in payment for exports, and hold it, will flee the greenback. Andy Xie, former chief economist at Morgan Stanley, Asia, writing in the Financial Times, expects inflation so severe that if China gets its policies right, and floats its currency “the renminbi’s rising credibility and its potential to replace the dollar as the main vehicle of wealth storage for ethnic Chinese” will, along with other developments, produce a “collapse” of the dollar. China’s recent decision to diversify its reserve holdings by buying gold might be an early warning of what is to come–reduced willingness to hold dollar assets that might drop in value if inflation takes off.

Look at it this way. Bernanke now has to decide whether the green shoots foretell a sustained recovery, and whether his policies and the President’s trillion dollar deficits threaten to trigger inflation. If the answers are “yes”, he then has to begin withdrawing cash from the system by selling back some of the assets he has recently added to the Fed’s balance sheet. That will displease his political masters, who do not want anything to interfere with a recovery on the eve of next year’s congressional elections. President Bush the elder still blames his failed re-election bid on Alan Greenspan’s refusal to loosen up on money in time to get the economy in high gear, rather than merely in early recovery mode, before the voters trooped to the polls in 1992.

I know–the Fed is independent of the politicians. After all, in the 1980s the fabled Paul Volcker, trotted out by Barack Obama for photo ops early in the first 100 days but now sidelined, did wring double-digit inflation out of the system by allowing interest rates to top 20 percent even though the unemployment rate jumped to a previously unthinkable 8 percent.

But Volcker had the support of President Reagan. Bernanke might not be so lucky. For one thing, by cooperating closely with the Treasury and the White House, he has forfeited some of the Fed’s independence. “Independent central banks don’t do what this Fed has done,” says Meltzer. Bernanke, it seems, is not the only central banker to have gotten too close to politicians as the recession took hold. Central banks have become “arbiters of which types of borrowers get credit,” writes The Economist, “dragging [them] back towards political turf from which they had been distancing themselves for years.”

For another, Bernanke is in an awkward position. Although his term as a board member runs until January 31, 2020, his term as chairman expires at the end of January 2010. Should he cool the economy too much, too soon, and threaten to cost the Democrats seats in the congressional elections later that year, Obama has his chief economic advisor, Larry Summers, ready, more than willing, and able to step into the chairman’s shoes.

Remember, if Bernanke decides to put on the brakes, and let interest rates rise by refusing to buy all of the IOUs the Treasury will be selling to fund Obama’s massive deficits, he will be placing only one of two drags on the economy. The other is the tax increases that the President has announced, many of which will hit in 2011. With both interest rates and taxes up, “there’s a real danger that what appears to be a robust expansion will flame out,” writes Michael Darda, chief economist for equity traders MKM Partners, in The Wall Street Journal. Such a combination–an interest rate rise and a tax hike, a sort of one-two punch–is generally blamed for aborting the on-going recovery from the Great Depression in 1935-1936. If history repeats itself, don’t count on the president to leap forward to share the blame for any loss of momentum. Easier to blame the Fed, and send Summers in from the bullpen, and Bernanke back to Princeton.

Even if Bernanke is not burdened by the all-too-human desire to hold onto one of the world’s most exciting jobs, he must find life more than a little fraught these days. Wait too long to tighten, and double-digit inflation and a dollar stripped of its role as a reserve currency will be his legacy. Act too soon, and risk strangling the recovery in its crib.

Of course, it is possible that fears of inflation are misplaced. After all, a recent sale of Treasury IOUs went well, suggesting that investors aren’t terribly worried that inflation will drive down the value of these securities. Some economists even worry less about inflation than about deflation–a persistent, broad decline in the price level that forces creditors to repay loans with very expensive dollars, lowers prices so as to reduce the return on business investment made when equipment prices were higher, and depresses wages.

Unless, of course, Rosy Scenario returns for one more romp around the economy. The economy has substantial excess capacity: factories are under-utilized and there are plenty of workers to be hired as the economy recovers. This will prevent prices and wages from rising as the economy grows. The green shoots will be in full flower by the time inflationary pressures emerge. The members of the Fed “concentrate excessively on the near-term and almost never discuss the medium- and long-term consequences of their actions,” according to Meltzer. That charge Bernanke denies. He claims that the Fed is “focused like a laser beam” and has spent its recent two-day meeting on developing an exit strategy to avoid inflation. “We have a plan in place [and] are trying to strengthen and improve it.” Now all he has to figure out is when to activate it. Anyone who has tried to call the turning point in a recession can only hope he does a better job than many of his predecessors.

Irwin M. Stelzer is a contributing editor to THE WEEKLY STANDARD, director of economic policy studies at the Hudson Institute, and a columnist for the Sunday Times (London).