10.01.2008 0

Extended Stay in Inferno

  • On: 10/21/2008 21:48:36
  • In: Monetary Policy

  • “We are at a Smithian moment, in which the temptation for the Fed to spend its last dime of credibility may prove irresistible. Investors are already being taxed by inflation and can rationally expect that tax rate (the inflation rate) to be raised going forward. Wages are not keeping up. Main Street is being taxed to fund Wall Street excess. Anyone who works, saves and invests is exposed to confiscation of his capital and earnings through inflation… If the Fed maintained its independence of action and said no to the inflationary finance of Congress’s profligacy, we wouldn’t have reached this point. But the Fed has forsaken that independence amid an absence of leadership.”—Gerald O’Driscoll, “Washington Is Quietly Repudiating Its Debts,” August 22nd, 2008.

    It appears Dante and Virgil will be spending a bit more time in Inferno than hoped for.

    Inflation is here to stay. Sure, the dollar is on a slight rebound this month. Commodities prices are coming down. Crisis over, right?

    Think again. The current strengthening of the dollar is as a direct result of the commodities bubble popping, and also is relative to inflation and the weakening of foreign currencies occurring overseas. What changed? Well, certainly not the Fed’s easy money policy. The Federal Funds Rate remains at a meek 2 percent.

    Instead, global economic growth slowed because of inflation and soaring energy costs, as did demand for energy. Thus, prices finally spiked and began to come down. But if the only way to bring inflation under control were to go into recession, the U.S. would have never needed President Ronald Reagan and Paul Volcker’s strong dollar policies after the stagflation of the 1970’s.

    As noted by Brian Wesbury in “Inflation Is a Clear and Present Danger,” the Fed has unlearned the lessons of the Nixon-Ford-Carter era:

    “The most painful and frustrating economic policy blunder of the past 50 years was the Great Inflation of the 1970s. Painful, because it was the catalyst for three damaging recessions (1973-75, 1980, 1981-82), all the while eroding living standards and seriously undermining confidence in America.

    “It was also deeply frustrating. Despite the teaching of Milton Friedman — which clearly explained that inflation was caused by too much money chasing too few goods — a combination of bad economic models, denial and political expediency allowed it to happen.

    “One would think that the odds of a repeat were low, and for 20 years, after Ronald Reagan and his Fed Chairman Paul Volcker had the courage to get inflation under control with tight money and tax cuts, this was true. Unfortunately, the lessons seem to be fading. Today, the U.S. (and through it the world) faces its greatest threat from inflation in 30 years. And as in the past, this threat is being met with denial and political expediency.”

    Mr. Wesbury traces today’s inflation problems to 2001, “when the Federal Reserve overreacted to the deflationary mistake it made in the late 1990s. The Fed vigorously pumped money into the economy in order to drive interest rates down rapidly.” And, predictably, inflation began a surge:

    “[A]s always, when the Fed injects excess liquidity into the system, inflation begins to rise. As early as 2002, soaring commodity prices and a falling dollar became the canaries in the coal mine of excessively loose monetary policy.

    “In their wake, almost every measure of inflation in the U.S. has moved significantly higher. In the past year, producer prices have increased 9.2%, while consumer prices are up 5.6%. Yet, because there are so many measures of inflation it is possible to focus on some, for instance consumer prices excluding food and energy (aka, “core” CPI), which remain benign. This allows many to say there is no inflation.

    “But oil and food are absorbing a large part of excess Fed liquidity. When consumers spend more on energy, they have less to spend in other arenas. This reduces demand for other goods, keeping prices lower than they would be otherwise. This helps explain the divergence between overall and core measures of inflation.”

    Mr. Wesbury goes on to note that even though current commodities prices are dropping, that this is not a new trend, but a market correction. He warns that 1970’s-like inflation could be in the tea leaves should monetary policy remain too easy:

    “It took 20 years of accommodative monetary policy in the 1960s and ‘70s to create the Great Inflation… With the real (or inflation-adjusted) federal-funds rate now negative, the signals are clear. The Fed is still adding more money to the system than is demanded, and this suggests that the general increase in inflationary pressures will continue. The only question is whether policy makers will get the courage to fight inflation before it gets out of control.”

    It’s a good question. If there is no courage from the Fed to fight inflation, then Dante and Virgil will have to abandon hope and spend a bit more time in Inferno than necessary, and the world’s inflation problems will be long-term.


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