The fog of the Fed's anti-deflation war
nationalpost.com
Terence Corcoran
Financial Post
Thursday, May 08, 2003
Want to know why the Canadian dollar jumped and the U.S. dollar tanked this week? Read this:
"Recent readings on production and employment, though mostly reflecting decisions made before the conclusion of hostilities, have proven disappointing. However, the ebbing of geopolitical tensions has rolled back oil prices, bolstered consumer confidence, and strengthened debt and equity markets. These developments, along with the accommodative stance of monetary policy and ongoing growth in productivity, should foster an improving economic climate over time.
"Although the timing and extent of that improvement remain uncertain, the Committee perceives that over the next few quarters the upside and downside risks to the attainment of sustainable growth are roughly equal.
"In contrast, over the same period, the probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level. The Committee believes that, taken together, the balance of risks to achieving its goals is weighted toward weakness over the foreseeable future."
By any standard -- English language usage, logical consistency, clarity of statements -- this is as compact a sample of inconclusive writing as has ever been included in any grammar textbook. What it means as economics is even more of a mystery. The financial markets took one look at the words, produced by the U.S. Federal Reserve's open market committee on Tuesday, and rushed to get out of the U.S. dollar and into other currencies, any other currencies.
The last sentence in the statement is the clincher. Essentially, the Fed appears to be confessing that it has little chance of achieving its own policy goals -- whatever they might be.
These are tough times for central bankers. When economies are booming, they look good and everybody assumes the bankers who decide how much money to print know exactly what they're doing. When the going gets tough, the gaping holes and weaknesses in central banking theory are on full display.
The Fed's statement is a masterpiece of pointlessness. Who needs to be told that the chances of the economy going up or down over the next six months are 50-50? The Fed's description of its inflation dilemma, however, is the real source of the outburst that rattled the world currency markets. By dropping an official hint that the United States just might be heading into a period of deflation, the Federal Reserve gave fresh life to the idea that the Fed could lower interest rates even further so as to deliberately create inflation.
The word "deflation" wasn't used, but it dominated the flood of post-statement analysis. The Fed's official concern about a "minor" risk of a substantial fall in inflation was taken as a sign that deflation is the dominant worry. The theory is that deflation, falling prices, would cause consumers to reduce spending and halt debt growth, turning the United States into a giant version of Japan.
That the Greenspan Fed should introduce fear of deflation is something of a surprise. Only the Fed can create deflation through its own monetary operations. By running a monetary policy that caused a contraction in the supply of money over an extended period of time, the Fed could create conditions that produced falling prices. No such contraction has occurred.
So what is the Fed up to? Why would it suddenly start issuing signals that are more confusing than usual? In this case, the signals are doubly confusing. The growth outlook is presented as a toss-up. There is a minor chance of deflation, and an even lesser chance of more inflation. One explanation is that the members of the Federal Reserve are divided on the state of the economy and inflation, and the statement merely passes that confusion on to the rest of us.
Similar signs of confusion have emerged out of the Bank of Canada, which has been dealing with the opposite problem. Canada faces risks of rising inflation, while the United States is grappling with lower inflation. Both banks tend to want to avoid taking responsibility for prices, whether they're rising or falling. They blame everything around them, forces beyond their control, for movements in prices. In the end, though, only central banks determine how much inflation we get.
These bouts of uncertainty, publicly and confusingly outlined, only multiply economic problems. The Fed's interest rate policy, including speculation that rates will be lowered further, is driving the U.S. dollar down. The more the Fed and some of its members fan speculation that a new anti-deflation regime is taking shape, the more investors and traders are going to adjust their activities to avoid the consequences.
Some of this uncertainty may dissipate over the next few months if the U.S. economy shows more signs of recovery. If it does, it will be no thanks to the U.S. Federal Reserve, which, at a time when prospects are good, officially injected the new and alarming prospect of a war on deflation. |
