Stories >> Economics

Allan Meltzer: Three Strikes Against the Fed

The Obama Administration, the Federal Reserve, and independent economists have to answer the central question about this recovery. Why did the enormous, sustained monetary stimulus have so little effect on real output, employment, and prices?

My answer is in two parts. First, the Federal Reserve's policy is based on major economic errors. It tried to resolve real economic problems by printing money. They should know that is not possible. Second, the real problems were created by the Obama administration. Its insistence on imposing costly regulations on firms and industries, its support for stronger labor unions, its opposition to tax reduction, and its other policies based on what the Economist magazine called "the Criminalization of American Business" have hampered the economic recovery.

The principal result was slow investment and increased pessimism about the state of the economy. Evidence of the latter are the decisions by many major companies, like Halliburton, Time Warner, Merck, Apple, and Walmart, to repurchase their shares at the very high prevailing stock prices instead of investing in new capital.

Six years into the recovery, median income remains much below the pre-recession peak. The unemployment rate has fallen, but that's mainly because of decisions by prime age workers to leave the labor force. And much of the increased employment is part-time work. An administration that declares its support for the poor and minorities has done far less to help them than the Reagan administration did over twenty years ago. Shouldn't the administration wonder why its policies have had such abysmal results?

Federal Reserve Errors

The Federal Reserve made three major errors. After responding appropriately to the 2008 financial crisis, it continued the policy of massive expansion of bank reserves long after such expansion was required. Surely by 2009, the Fed could have seen that most of the reserves that it supplied ended as idle reserves held by banks. With low investment in new capital and housing, the financial system had little demand for additional reserves. How did the Federal Reserve explain the sluggish growth of bank lending? Long before idle reserves reached $ 2.7 trillion, the Fed should have asked: What can we achieve by adding more reserves that the financial firms do not use that commercial banks cannot achieve by using some of the idle reserves they hold? Apparently that question was not asked.

The accumulation of idle reserves was not the only sign that monetary policy had little impact on the real economy. I have often written that the transmission of monetary policy to the real economy occurs, first, by raising the price of existing assets. Stock prices and the prices of existing homes are examples. And that happened. Asset prices increased substantially.

The next step followed weakly, or not at all. In the recovery from a monetary recession, the rise in stock market prices and the prices of existing houses makes the prices of new capital and new homes relatively cheap. That's the main channel through which money growth affects real economic activity. Relatively cheap new capital induces new investment by business and the production of new housing. This time the percentage of home ownership is at 64, well below the earlier peak of 70 before the recession. The failure of business investment to expand and the weak increase in new housing was a message to the Fed. It read: The main problems of this economy are real not monetary.

In 2010, Harvard Business School's Professor Michael Porter and a colleague asked 10,000 business school alums why they were not investing. The respondents were involved in investing decisions at major U.S. corporations. Their answers cited real problems, not monetary or financial problems, as the reason for sluggish investment. Since the problems businessmen see are not monetary, the Fed cannot eliminate them.

The Affordable Care Act (Obamacare) encourages employers to prefer part-time workers to escape expensive healthcare costs. Fed principals point to the rise in part-time employment as a reason for continuing to keep interest rates near zero. Are they so confused that they think that financial policy can counteract costly real government rules?

A second major Fed error is the excessive attention the Fed gives to very noisy monthly and quarterly data. An example was the emphasis for years on the monthly report on job growth. It soon became clear that a big increase encouraged beliefs that the recovery was gaining momentum. The next month the number was revised, often reduced considerably. Discouraging monthly reports were often followed by positive revisions. By relying on a very noisy indicator, the Fed increased uncertainty. More importantly, it showed that it over-reacted to current events and did not have a coherent strategy.

It still doesn't. Reducing $2.7 trillion of excess reserves requires a long-range plan conditional on events. Eliminating the excess reserves without causing inflation, recession, or both is a major problem for the future. The Fed cites overnight purchases of reserves from the financial market as a way of controlling reserve growth. That's not a credible strategy for reducing more than $2 trillion dollars of reserves.

The two best periods in the Fed's first 100 years are 1923-28 when the Fed followed a rule called the gold exchange standard and 1986-2003 when the Fed more or less followed a Taylor rule. Economists call the latter period, the Great Moderation. Inflation was low, recessions were infrequent, and when they did occur, they were mild and short. Instead of responding to noisy monthly and quarterly announcements, the Fed followed a medium-term strategy. It should do so again by announcing and following a Taylor rule.

The Fed's third major error is inattention to growth of monetary and credit aggregates. This decision is baffling. Central banks supply the raw material on which financial markets build the credit and money magnitudes. The reason given for neglecting these aggregates is usually a claim that they are unstable. That is true only, if at all, of quarterly values. It is not true of medium- and longer-term values as many researchers have shown.

Our Major Economic Problems Are Not Monetary

Obama administration policies are the principal reason that unprecedented monetary expansion was followed by the slowest growth of any recovery since World War II. Soon after taking office, the Obama administration adopted a huge program of government spending, worth almost $ 1 trillion. Much of the spending went for redistribution. Very little encouraged increased productivity, the main source of better jobs and higher living standards. The program accomplished little.

After this initial effort, the Obama administration has given most of its attention to increasing costly regulations, bringing often vague criminal charges against corporations, criminalizing businesses, and redistributing income. Its major effort to redistribute income failed to achieve its end. These programs discourage new investment, so business investment remained low and will not increase if these policies continue.

To restore investment and growth, the government should deregulate, stop criminalizing corporations, and reduce tax rates. The shift in political power after the 2014 election gives reason to hope that better policies will encourage more investment.

A New Error?

Currently, some Fed principals express concern about deflation. Their error is to mistake a large decline in the oil price—a relative price change—with a decline in the general price level. This is the same mistake the Fed made in the 1970s when oil price increases became the reason for anti-inflation action. By the early 2000, the Fed recognized its error and allowed the oil price to pass through the economy.

That's the correct policy response to the sharp decline in oil prices: Do nothing, even if the reported index becomes negative for a few months. The Fed has many competent spokesmen who can explain to the public why it is wrong to treat the decline in oil prices as deflation. They can explain that deflation occurs when enough different prices decline that broad based price measures fall. The Fed has the authority to explain the reasons for inaction and why it is appropriate to permit the fall in oil prices to work its way through the economy.


Inappropriate administration and Fed policies are the reason why weak recovery followed the enormous monetary stimulus. After preventing a major financial crisis in 2008, the Fed has pushed discretionary policy in an extraordinary effort to restore full employment. The effort failed to achieve its goals. It continued long after the Fed should have recognized that monetary policy could do little because the problems were not monetary. They were real.

The Obama administration was the principal source of the economy's real problems. Costly regulations, relatively high tax rates, and redistributive spending added to the neglect of the long-term implications of unsustainable budget and off-budget deficits.

Finally, the Fed's recent expansion raises an issue about the power of the Fed to quadruple the size of its balance sheet without any effective Congressional oversight. In a federal republic such as ours, no government agency should be able to take such action on its own initiative.

This essay is adapted from a paper presented at the Chicago Federal Reserve Bank that the Bank declined to publish in its conference volume

Click to Link

Posted: January 15, 2015 Thursday 06:00 PM