Yellen should go slow: there's no need to rush to "normalize" U.S. monetary policy.

• Author: Berry, John M.

Unless there is some unexpected slump in the U.S. economy, it's clear the Federal Reserve will continue to trim its monthly purchases of Treasury and mortgage-backed securities--which were down to $45 billion in May from $85 billion at the end of 2013--and wrap up its quantitative easing program by the end of the year. In congressional testimony in May, however, Federal Reserve Chair Janet Yellen made it equally clear that she does not intend to rush to normalize monetary policy.

Normalization, historically, Yellen said, would be moving back to a short-term interest rate target of around 4 percent when the economy is close to full employment. But that is not a targeted commitment from the Federal Open Market Committee, she stressed. "We anticipate that even after employment and inflation are near mandate-consistent levels, economic and financial conditions may, for some time, warrant keeping the target federal funds rate below levels the committee views as normal in the longer run."

The Fed official target for inflation, as measured by the personal consumption expenditure price index rather than the narrower consumer price index, is 2 percent. In the twelve months ended in March, the PCE price index rose just 1.1 percent. After a 0.3 percent increase in April, the CPI was up 2.2 percent over the past year.

Conservative Fed critics were undoubtedly appalled by such a bold statement from Yellen. Many of them were already complaining that the Fed's easy money policies over the past six years--a policy that has caused the central bank's balance sheet to balloon to $4.4 trillion--have made a burst of high inflation unavoidable. For instance, Allan Meltzer of Carnegie Mellon University, a leading Fed historian, warned in a May Wall Street Journal op-ed column, "Never in history has a country that financed big budget deficits with large amounts of central bank money avoided inflation. Yet the United States has been printing money--and in a reckless fashion--for years."

At a hearing of Congress's Joint Economic Committee, the chairman, Rep. Kevin Brody, a Texas Republican, asked Yellen to respond to Meltzer's complaint. She said, in so many words, that he was wrong. The "formative years" professionally for many of the FOMC members were the 1970s when overly easy Fed policies allowed inflation to skyrocket, and they won't let that happen again. "I do believe that we have the tools and absolutely the will and the determination to remove monetary accommodation at an appropriate time to avoid overshooting our inflation objective," Yellen declared.

Without a doubt, the increase in so-called base money has been enormous. As Meltzer noted, there are "more than $2.5 trillion of idle reserves on bank balance sheets" which could provide "fuel for greater inflation once lending and money growth rises."

But having tinder doesn't always mean there's going to be a fire, and so far few of those idle bank reserves have been used to fund loans. Without that lending to cause the monetary aggregates to grow rapidly, the reserves won't trigger more inflation. In fact, some analysts, such as John Makin at the American Enterprise Institute, fear that with the fall in the velocity of money, the danger isn't more inflation but deflation. In a recent article, "Now Is the Time to Preempt Deflation," Makin argued that deflation, not inflation, was a risk not just in the United States but also in Europe and China. Japan, of course, has been wrestling with deflation for years.

With...