Greenspan has already lost the inflation fight
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
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.