Low Rates, High Expectations
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By JAMES GRANT
OP-ED CONTRIBUTOR
THE NEW YORK TIMES
May 16, 2004
nytimes.com
Inflation is returning to the American checkout counter under the unlikely sponsorship of the Federal Reserve. For the past year, the Fed has been striving to make the dollar buy less. It's well on its way to succeeding, to judge by the recent readings on wholesale and consumer prices.
Why the Fed decided to propagate inflation, after having so long battled against it, is a story that begins with the return to common usage of an old word. Late in 2002, officials began to warn of the danger of "deflation," or broadly falling prices. Everyday low prices are well and good, the central bankers allowed. Yet if prices steadily and predictably fell, people would stop buying things. They would stay home to wait for tomorrow's guaranteed lower prices. And if the American consumer stopped shopping — and borrowing to shop — where would we be?
So, last June 25, the Fed pushed the federal funds rate, the rate it directly controls, down to 1 percent, the lowest since the second Eisenhower administration. And it warned that "the probability, though minor, of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from its already low level."
Before the Fed was founded, in 1913, there were recurrent cycles of inflation and deflation. In general, prices rose in wartime and fell in peacetime. In the last quarter of the 19th century, prices persistently fell. Technological innovation pushed down costs, and lower costs translated into lower prices. Wage-earners flourished as the spending power of money increased. Creditors prospered, too, as interest rates declined.
Then, about 1900, the world struck gold — in Alaska, Colorado and South Africa. As gold was then the monetary asset on which national currencies were based, the world, in effect, struck money. For the next two decades, prices went up.
It is a relatively new thing in finance that prices should not be allowed to fall. The Federal Reserve implicitly admits as much. On the one hand, it extols the rising productivity of the United States economy. On the other, it declares that this extraordinary progress should not be registered in falling prices. In so many words, the central bank says that what is good for Wal-Mart's customers is not necessarily good for the country.
The Fed doesn't literally print money. Instead, it manipulates the interest rate that induces others to print money. In a modern economy, money-printing takes the form of credit creation, i.e., lending and borrowing.
There has been a great deal of this in recent years. By any and all measures, America is more heavily indebted than ever before. In 1958, when the funds rate was last at 1 percent, the economy's overall indebtedness was about half of today's. Back then, overall debt (excluding the borrowings of banks and the federal government) represented 84 percent of gross domestic product. Nowadays, it stands at 163 percent of G.D.P.
The weight of this indebtedness, foreign as well as domestic, helps to explain why the Fed set its rate so low. One percent is an emergency rate, unseen before the institution of the Fed and only rarely since. It was the rate intended to raise the economy from the Great Depression and to see it through World War II and the immediate cold war era.
The Fed chairman, Alan Greenspan, and his colleagues keep saying that there is no emergency — that, on the contrary, the United States economy is a paragon of strength, lacking only an acceptable rate of job creation. Yet they have kept their rate at the emergency setting, thus fomenting a real-estate boom on Main Street and a stock-and-bond boom on Wall Street.
Now the 1 percent era is fast closing, and financial markets worldwide are shuddering. As the signs of inflation multiply, the Fed finds itself in a very interesting position. It never wanted much inflation, it protests; just a whiff would suffice.
But the subjects in the central bank's monetary experiment are human beings, not laboratory mice. When people sense that prices are going to rise, they take steps to protect themselves. They buy extra inventory, invest in so-called hard assets (houses, not bonds) and pass along their rising costs as best they can. Once instilled, inflationary habits are hard to break, as the Fed exactly understands.
And the Fed will raise its rate, though grudgingly and gradually. It will act in this fashion not only out of conviction but also, perhaps, out of a guilty conscience. It knows that its 1 percent rate drove many risk-averse people into stocks and bonds because they could no longer afford to live on the meager returns of their savings. That is at one pole of the spectrum of financial sophistication. At the other, hedge funds borrowed at ultra-low rates to speculate in everything from gold to lead. Just the prospect of a slightly higher borrowing rate has brought about disturbances in the temples of high finance.
The Fed has another reason to be conscience-stricken. It knows, or should know, that by trying to make the dollar cheaper, it has precipitated even more borrowing in an economy heavily encumbered. The greater the debt, the more deflation-prone the economy. And the more deflation-prone the economy, the more the Fed is apt to try to cheapen the dollar. The truth is that the central bank of the United States is chasing its tail.
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James Grant is the editor of Grant's Interest Rate Observer. |
