Allan Meltzer on Inflation

Episode Summary

Executive Summary: Alan Meltzer argues the Fed’s crisis response in early 2009 is massively expansionary but not yet inflationary because banks and investors are hoarding reserves and Treasuries amid fear and policy uncertainty. He warns that once confidence returns, the huge monetary base and fiscal deficits could fuel serious inflation unless the Fed reverses course and authorities resolve weak banks by forcing capital raises, closures, or reorganizations.

Main Topics: The Fed’s unprecedented balance-sheet expansion (Priority: 5/5): Meltzer explains that the Fed has massively expanded reserves and bought illiquid assets, including mortgages and commercial paper, far beyond traditional Treasury-only operations. Why current expansion has not yet produced inflation (Priority: 5/5): He argues that fear, uncertainty, and excess reserve hoarding are preventing the new money from circulating, but this is temporary and inflationary pressure is latent. Treasuries, foreign central banks, and global dollar demand (Priority: 4/5): The discussion covers swap lines, foreign banks’ demand for dollars, and the role of Treasury issuance plus Fed-created reserves in funding U.S. deficits and supporting the dollar. Bank rescues, too-big-to-fail, and moral hazard (Priority: 5/5): Meltzer contends that repeated rescues created expectations of bailouts, encouraging excessive risk-taking and making the crisis worse. How to repair the banking system (Priority: 5/5): He advocates using FDICIA-style resolution: force capital raises, close insolvent banks, remove management and shareholders, and let healthy institutions acquire the rest. Japan, monetary policy, and the limits of fiscal stimulus (Priority: 3/5): Using Japan’s lost decade as a case study, he argues fiscal spending alone failed and that monetary expansion would have worked if pursued seriously. Housing policy, Fannie/Freddie, and Greenspan’s low rates (Priority: 4/5): Meltzer blames housing subsidies, GSE expansion, and the Greenspan-era low-rate policy for amplifying the mortgage boom and leverage.

Key Arguments: The Fed is expanding its balance sheet by buying illiquid assets and issuing reserves on a scale that is historically extraordinary. Money growth and reserve growth are already large; inflation is delayed only because banks and the public are holding cash and Treasuries instead of lending or spending. Once confidence returns, excess reserves and liquid assets will likely be deployed, creating strong inflationary pressure unless the Fed acts to withdraw them. Current deflation fears are overstated because temporary declines in oil and food prices are relative-price changes, not true sustained deflation. Too-big-to-fail policies and ad hoc bailouts create moral hazard, encouraging banks to take excessive risks on the assumption of rescue. The proper solution to weak banks is not subsidized capital or accounting changes, but recapitalization, closure of insolvent firms, and management replacement under existing law. Quantitative easing is not a new concept in his view; it is simply the Fed buying different assets, and it still can work if confidence returns. Japan’s experience shows that fiscal stimulus without real monetary expansion can fail, while persistent money growth and bond purchases can eventually work. Low short-term rates can also depress long-term rates by shaping expectations of future policy, helping to inflate asset bubbles like housing. The housing crisis was worsened by government support for mortgage finance through Fannie Mae and Freddie Mac, which expanded massively off-budget.

Data Points: Fed balance sheet growth: 1.5 times larger - Meltzer says the Fed’s balance sheet has expanded dramatically in response to the crisis. Annualized reserve growth: Thousands of percent - He describes reserve growth as extraordinarily fast and unprecedented. M2 growth: About 20% annual rate - He cites six-month money growth as evidence of strong monetary expansion. Fed Treasury bill rate / policy rate context: Close to zero - Used to explain why banks can hold reserves and Treasuries while remaining cautious. Treasury yield level: Very low - He attributes low Treasury rates to global demand and safe-haven behavior. Federal deficit: $1.2 trillion - CBO estimate for the year before the new stimulus plan. Bear Stearns assets: $29 billion - Fed-backed purchase of unsaleable Bear Stearns assets in the crisis response. Bear Stearns toxic assets later referenced: $32 billion - The guarantee ultimately covered a larger amount than initially described. Mortgage securities market price: About $45 per $100 - His estimate of market value for distressed mortgage bundles. Expected 2009 house price decline: 11% - Used to explain why mortgage-backed assets were hard to value. Housing finance scale: From about $400 billion to $2.5 trillion - Growth in Fannie Mae and Freddie Mac mortgage market activity over roughly 25 years. Bank leverage: Up to 35 to 1 - Example of extreme leverage that could wipe out equity after a small asset decline. Long-term rates under war-era peg: Capped at 2.5% - Used as a historical example of pegged rates contributing to inflation. Unemployment in 1970s Fed example: About 7% - Meltzer cites this as the level at which the Fed historically shifted priority toward employment over inflation.

Pivotal Quotes: "It has reserves growing at rates that are in the thousands of percent annual rate." — Alan Meltzer: Describing the Fed’s crisis-era monetary expansion. "Too big to fail is a policy which invites people to take excessive risks." — Alan Meltzer: Explaining moral hazard and why banks took on dangerous leverage. "We’re never going to get out of this problem unless we allow banks to fail." — Alan Meltzer: His central prescription for cleaning up the financial system.

Implications: Meltzer’s warning is that crisis-era liquidity is a delayed inflation problem, not a solved one. If policymakers keep rescuing weak banks and delay tightening, the eventual rebound could bring sharp inflation, distorted incentives, and more instability.