Federal Reserve chairman Bernanke testified last Tuesday (July 21) that there is no inflation danger even though the Fed is keeping short-term interest rates very low and the banks are awash with excess reserves (lendable cash), to the tune of some $800 billion, which if used for loans rather than left sitting in the banks' accounts in federal reserve banks would increase the amount of money in circulation by a considerable amount. Bernanke explained that if signs that unwanted inflation is looming appear, the Fed can head off the inflation in a variety of ways. One way, he emphasized, would be by paying interest on reserves at a rate that would increase the interest rates that banks would charge for loans and by doing so reduce the amount of money in circulation. Suppose the Fed paid 3 percent interest (at present it is paying .25 percent) on reserves; then a bank would have no incentive to lend at any lower rate. Indeed, it would insist on a significantly higher rate, since lending to the Fed (the banks' excess reserves are held in federal reserve banks, and so in effect are loans to the Fed, on which the Fed pays interest) is riskless. Another way to stop inflation would be for the Fed to sell securities to the banks (or to others) and retire the cash it received, thus reducing the amount of money in circulation. It could do other things as well.

But there are two clouds in this otherwise sunny scene. The first is that the device for reducing the amount of money in circulation with which Bernanke led in his testimony--paying interest on bank reserves on order to increase interest rates--has not been tried before by the Fed. It sounds as if it would work, but until it is true, no one can know.

Second and more serious, is a statement last Thursday by Richard Fisher, the president of the Federal Reserve Bank of Dallas and a member of the Federal Open Market Committee of the Fed, which controls (or tries to control) the money supply. After summarizing Bernanke's "exit strategies" from the current "easy money" Fed strategy, Fisher said that "We [that is, the Fed] know full well that monetary policy trickles in with a lag and that we will have to 'pull the trigger' of tightening policy well before it is politically convenient."

What I think he meant was the following. As the economy recovers, cash hoarding will decline, and cash in circulation will therefore increase. The ratio of cash to goods and services will therefore rise, quite possibly faster than output, and so inflation will increase. Even if the Fed can stop the rising inflation in its tracks (as Fisher is confident it can), it may by doing so slow or even stop the recovery--and at a time when the unemployment rate will probably still be very high.

For a time, as in 1979-1982, high interest rates, engineered by the Fed to stop inflation, may coexist with both high inflation and high unemployment--an immensely politically unpopular combination, which helped Reagan beat Carter in 1980. Partly because of Volcker's personality, partly because of Reagan's ideology, the Fed was allowed to crush inflation at the cost of a severe recession in the early years of Reagan's presidency.

If history repeats itself, I have no doubt that Mr. Fisher will vote to pull the trigger, because he is a famous inflation hawk. But will Bernanke, or his successor if he is not reappointed? And a majority of the Federal Open Market Committee? The Fed does not operate in a political vaccuum. It has no constitutional independence from the political process. It is unpopular in Congress, and Democrats are not as hawkish about inflation as Republicans are.

I think Fisher is overly optimistic about the Fed's willingness to "pull the trigger" regardless of "political inconvenience." At the other end of the political spectrum, liberal economists like Paul Krugman are I think overly optimistic about price stability. They argue that inflation is no danger, period. They argue that the economy has so much slack that it can absorb hundreds of billions in cash for years without any effect on price. But I suspect that what they actually believe is different, is that inflation, unless it gets out of hand (unless it exceeds 10 percent, say), is not such a big deal. (In fact, as I have pointed out in earlier blog entries, inflation during a depression is an economic plus because it reduces debt burdens and by doing so encourages consumers to spend. But I am talking now about the recovery phase of the business cycle.)

Inflation is a tax on cash balances and on fixed-interest loans. It is not an efficient tax, but few taxes actually imposed in our political system are efficient. It would be interesting to see a serious economic study of the social costs, and possible social benefits, of allowing inflation to rise above normal levels in the recovery phase from the current economic situation.