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To: kendall harmon who wrote (97333)	5/12/2000 12:29:00 PM
From: Lane Hall-Witt	Respond to of 120523

Kendall, Thanks for posting John Berry's article this morning. It's overwhelmingly clear that the Fed has no idea what's going on and that its thinking is, at best, utterly conflicted. Another thing that's overwhelmingly clear is that the Fed's aggressive approach to interest rates is extremely risky and could ultimately succeed in triggering inflation and imploding the economy. The primary threat to the economy is the potential imbalance between the demand for goods and services and our economy's capacity to supply that demand. This is the Fed's stance, and I largely agree with this premise. In cases where we are worried that demand exceeds supply, the ideal solution obviously is to cut demand while maintaining or enhancing supply. The problem with raising interest rates is that it's hard to be sure if this is going to affect demand or supply more quickly and/or more aggressively. What if increased interest rates lead to greater declines in production than in demand? That ultimately would enlarge imbalances between supply and demand, rather than trimming them. This is a clear recipe for rising prices -- that is, for inflation. I find it deeply disturbing that the Fed is trying to reduce corporate capital investment at a time when demand threatens to outstrip supply. The argument seems to be that capital investment leads to wealth creation, which leads to more consumer spending, which exacerbates the trend toward a supply-demand imbalance. But this chain of reasoning overlooks the fact that capital investment underlies the productivity growth that has helped meet heightened demand and stave off inflationary excesses of demand over supply. Which is the more powerful economic force: productivity, which increases supply, or the wealth effect, which ups demand? I also can't stand the fact that the Fed economists -- and virtually all other economists -- think that there is a short-term relation between corporate cost pressures and inflation. There is absolutely no short-term need for cost pressures to lead to increased prices. None! If companies don't have pricing power, they can't raise their prices no matter what their costs are. What can happen in an absence of pricing power is that companies suffer a profit squeeze as margins trend downward. Over the long run, high-cost producers should ultimately go broke as costs exceed their ability to price their products . . . and this should reduce supply and create pricing power . . . which in turn should lead to increased prices . . . which we call inflation. The key to inflation is pricing power, which can be constrained either by limited demand (which we don't currently have) and corporate competition (which we do currently have). What if borrowing costs become so high that marginal producers get run out of business? Then competition diminishes, pricing power returns to the economy, and again we have a recipe for inflation. None of this even touches on the question Lee likes to point out, that there's an overabundance of money sloshing around the economy. The government has started to drain off M1 money supply (down 2 percent from January 2000 to April 2000), but M2 and M3 grew an astonishing 7.2 percent from January to April, despite the fact that we cleared the Y2K threat without any significant pressure on money supply. federalreserve.gov One last thing: for all the bitching and moaning I've just done about the Fed and its economic modeling, I'm thankful that I don't have to be making their decisions. That's a tough gig those Fed governors have!