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Batten Down the Hatches

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05/10/2009 10:42 AM
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Batten Down the Hatches
Bernanke may need Rosy Scenario's help to stem inflation

By: Irwin M. Stelzer

Examiner Columnist 5/8/09 6:15 AM

Batten down the hatches. America is about to be overwhelmed by an inflationary wave that will threaten the value of the dollar and its ability to remain the world’s reserve currency. Or not.

Much of the news of late has been a lot cheerier than the reports that descended on us only a month ago. Which is not entirely good news for Ben Bernanke and his colleagues on the board of the Federal Reserve Bank.

Until now, they had an unambiguous goal: avoid a collapse of the financial system, and pump cash into the economy. Bernanke did what he had to do and, most observers agree, did it very well.

He drove interest rates down and devised 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 the economy might be picking up, all of that cash has driven the inflation rate to almost 3%, “a sure sign of inflation … Enormous budget deficits, rapid growth in the money supply and the prospect of a sustained currency devaluation … are harbingers of inflation”,” according to Allan Meltzer, an economics professor at Carnegie Mellon University.

And not just your garden-variety inflation, observers fear. Andy Xie, former chief economist at Morgan Stanley, writing in the Financial Times, expects inflation so severe that, along with some changes in China’s policies, it could produce a “collapse” of the dollar.

Bernanke now has to decide whether the green shoots foretell a sustained recovery, and whether his policies and President Obama’s trillion-dollar deficits therefore threaten to trigger inflation. If the answers are “yes,” he then has to begin withdrawing cash from the system.

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.

I know - the Fed is independent of the politicians. After all, in the 1980s the fabled Paul Volcker, trotted out by 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%, even though the unemployment rate jumped to a previously unthinkable 8%.

But Volcker had the support of President Ronald 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.

For another, he 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 abort the recovery, threatening 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.

If Bernanke does 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. Such a one-two punch -- an interest rate rise and a tax hike -- is generally blamed for aborting the on-going recovery from the Great Depression in 1935-1936.

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, Rosy Scenario might return 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 could prevent prices and wages from rising as the economy grows.

If inflationary pressures do emerge, Bernanke claims that the Fed is “focused like a laser beam…. 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.

Examiner columnist Irwin M. Stelzer is a senior fellow and director of the Hudson Institute’s Center for Economic Studies.

[link to www.washingtonexaminer.com]