Greenspan has already lost the
inflation fight
Albert Friedberg
National Post
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.
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