  |  | ||||
| |||||
        | |||||
Greenspan has already lost the inflation fight
By:
Date:
| |||||||||||||||
| Greenspan has already lost the inflation fight | | |||||||||||||
By: | | Albert Friedberg | | ||||||||||||
Date: | | 06/17/2000 | | ||||||||||||
| | | | ||||||||||||
|
| |
It is not, as many believe, that the Fed has been too timid in fighting inflation. It is far worse than that: Alan Greenspan's Fed has been blissfully misguided. Central bankers in the United States, and for that matter the rest of the world, have lost their true North. Aside from reiterating their strong commitment to fighting inflation, these central bankers lack the will and the proper understanding to conduct such a policy. Start with basics. Inflation is and always was a monetary phenomenon. Creating money in excess of the desire to hold money causes prices to rise. Very few serious economists doubt this simple assertion. Yet, central bankers insist on discussing everything but money when they explain policy: They speak about productivity, pools of labour, unemployment, real growth and so on, without once addressing the issue of the supply and demand for money (not to be confused with loan demand). Technology has made remarkable progress in allowing consumers and corporations to reduce the need for money. Witness, for example, the huge rise in the use of credit cards and ATMs, which eliminate the need to carry around bulging rolls of cash. What purpose would be served, in such a cash-efficient society, to allow cash balances or other transaction balances to grow year after year? Why has the central bank shoved money into an economy that clearly was not demanding it? The answer is that the Federal Reserve does not take into account the growth of monetary aggregates when it conducts its monetary policy. Instead of determining the quantity of money, it merely sets the price of money through interest rates, and in a highly discretionary manner at that. If the Fed merely regulated the quantity of money -- a policy called monetarism -- the free interplay of market forces would set interest rates. Focusing on supplying the right quantity of money, while still a highly imprecise exercise, would have given the Fed an anchor, albeit an imprecise one, on which to base policy. It would have had to justify the excessive growth (or the growth altogether) of transactional money, instead of expounding on the "right" level of interest rates. Fussing over the right level of interest rates is part of a socialist mind-set. Does anyone truly believe he can know the right level of prices for wheat, shoes, media spots or any other product in a free market economy? Why do central bankers think they know the right level of interest rates? Why do they praise free markets in everything but money? Setting interest rates affects the demand for money, which in turn, via interest rate intervention, affects the supply of money. An upside down world. True, monetarism was discarded in the late 1970s and early 1980s because of the difficulties of defining money. Nevertheless, the extraordinary progress in the fight against inflation was achieved, not coincidentally, by a very steady fall in the growth of money supply. From annual growth rates of 12% in 1983, growth in the broad M2 money supply fell to almost 0% by early 1995. The massive monetary shock administered in the early 1980s by Paul Volcker, then chairman of the Federal Reserve Bank, halted rising inflationary expectations almost in their tracks. As the demand for money grew and interest rates threatened to fall below the Fed's funds target rate, the Fed absorbed funds and the supply of money slowed to a crawl. Unintentionally, the Fed was following a monetarist prescription. Predictably, price inflation fell continuously over the 12-year span, to less than 2% from almost 15%. The upshot was that prices and inflation behaved as if monetarism were still in place. By the middle of the decade, the Fed's concern with inflation became mere lip service. The excellent behaviour of prices, reinforced by cyclical and secular productivity improvements, allowed the Fed great freedom. With the first global financial crisis, the Mexican Tequila affair, Fed policy changed, from an inflation focus to a crisis management one. Henceforth, Fed policy would be conducted with an eye toward averting systemic failures. The South Asian crisis, the Russian crisis and the Long Term Capital Management crisis saw the Fed at its paternalistic best. It set interest rates solely to help stave off a presumed financial collapse; its policies had lost any focus on creating supply of and demand for money that would yield a reasonable, let alone a zero, inflation rate in the medium term. In the meantime, asset inflation began to erode whatever goodwill the anti-inflation campaign had gained. Interest rates were set at levels that produced an excess supply of money; no longer could the Fed rely on the rising demand for money balances. The stage was set for a significant rise in inflation. Note, however, that consumer prices took some time to reflect this latent inflation. For one thing, commodity prices had taken a drubbing in 1997 and 1998, as a result of the Southeast Asian crisis. For another, the trade-weighted U.S. dollar, buoyed by large portfolio flows generated by a very strong stock market, rose by almost 20% in real terms since 1995, putting a powerful lid on import prices. The accompanying and growing trade deficit also did its part to help maintain reasonably steady prices. The lag fooled the Fed and most of the financial community into thinking, as late as the beginning of this year, that inflation was still under control. In fact, inflation has been out of control since at least the mid-1990s. It is just that consumer prices were being repressed by the temporary weakness of commodity prices and the rise in the U.S. dollar. Except for the still strong U.S. dollar, the corset is off consumer prices. Core consumer price inflation (even excluding tobacco) has risen sharply, as measured by either the personal consumption deflator (almost 3% year-over-year) or the core CPI (a shade above 2%). Note that consumer prices, unadjusted by the rise in food, energy and tobacco, have risen 3.7% year over year, the highest rate in a decade. Because money growth has been excessive for at least six years, we estimate that inflation rates are set to rise considerably before the Fed lands us into a recession, in a belated attempt to regain control. Unfortunately, our troubles will not end there. A recession will almost certainly weaken the U.S. dollar, removing in its wake the last corset. As consumer prices begin to gallop, financial markets will wilt, writhe and then implode. Glitzy theories about productivity miracles, Internet price-chopping and lack of pricing power will again be recognized as new versions of the cost-push theory of inflation. Money will once again take centre stage. And, as we never tire of saying, it will painfully be realized that money is too important to be entrusted to central bankers. Albert Friedberg is director-general partner of Friedberg Mercantile Group, a Toronto-based investment firm. | | | ||||||||
| ||||||||||||
