I wish more journalists who write about the Federal Reserve would read Gary Stern’s columns. They would gain insights that might keep them from egregious misinterpretations of monetary policy after Federal Open Market Committee meetings such as the one this week. The public would better understand just what is going on and what tradeoffs our society faces.
Stern is president of the Federal Reserve Bank of Minneapolis. As head of a district bank, he has participated in these committee meetings for nearly 20 years and attended as the Minneapolis director of research for three years before that.
No one else, including Fed Chairman Alan Greenspan, has as much experience on this key policy body. Moreover, Stern has a Ph.D. in economics and years of experience at the New York Fed before coming to Minneapolis.
The September issue of The Region, a quarterly magazine published by the Minneapolis Fed, contains the text of a speech by Stern on various economic issues. In a section headed “Inflation Confusion,” he corrects commonly held misconceptions about the nature and causes of inflation. The text of the speech is at http://www.minneapolisfed.org/publications_papers/pub_display.cfm?id=3315.
Stern argues that the idea there is a tradeoff between inflation and unemployment is “deceptively seductive.”
“There is a large body of empirical evidence, which holds both across countries and over long time periods, indicating that inflation is a monetary phenomenon,” he writes. “That is, in the long run, inflation results from excessive growth in the money supply, irrespective of conditions in the labor market. Moreover … empirical evidence since the mid-1980s shows no significant relation between unemployment and changes in inflation for the U.S. economy.”
If Stern is correct — and I strongly believe that he is — then all public hand-wringing is misguided about whether a quarter-point increase in a targeted interest rate is justified in the wake of any recent unemployment number. The Fed cannot increase employment by artificially depressing interest rates. Moreover, past efforts to do so have, on balance, harmed our society.
Perhaps not every Federal Open Market Committee member would state it quite this strongly. Moreover, they understand that a central bank should obey the Hippocrates injunction to “first, do no harm.” They know that unwarranted constriction of the money supply can harm an economy just as too-rapid monetary expansion can.
But they all know what causes inflation — excessive growth of the money supply. News reports of Tuesday’s quarter-point increase in the Fed Funds rate target contained statements to the effect that “the Fed believes it can ward off inflation by raising interest rates.”
Such phrasing implies that interest rates have some fetishistic power over inflation just as torches, crucifixes and stakes driven through the heart were supposed to control Dracula. It shows that writers are confusing cause and symptom.
Central banks can prevent inflation by not allowing the money supply to grow too quickly. For any rate of money growth that avoids inflation or deflation, interest rates will vary with the supply of lendable funds — that is, national savings — and the demand for such funds.
Interest rates are just a price. They reflect underlying forces of supply and demand, among which Fed actions are only one component, albeit an important one. Increases in interest rates may reflect that the central bank is limiting money growth to avoid increases in the general price level. They also indicate societal savings rates and willingness to borrow. Higher interest rates are not, in themselves, an anti-inflation tool. They are rather an indication that such a tool is in use.
The Fed has bent over backward during the last four years to ensure that lack of liquidity in the economy did not constrain growth in output or employment. It allowed the money supply to grow at rates that would have been inflationary if the economy had been stronger. That “accommodation” on its part showed up in historically low short-term interest rates.
But such monetary growth, while acceptable in the short run, cannot continue unabated without returning us to the bitter stagflation of 1975-1982. The Fed must limit money growth if it is to meet its statutory mandate to maintain stable prices. Interest rates must rise as a result, not as a cause.
We face a much greater danger that the Fed is moving too slowly rather than too quickly. Tuesday’s increase to 2.25 percent leaves much to be done. In only seven of the last 30 years, has the Fed Funds rate been below 5 percent. Historical averages for non-inflationary periods typically are in the 5 percent to 7 percent range. The Fed would have to tighten a quarter point at every meeting for two years to get back to such levels.
Our nation has been lulled into complacency by the fact that the central banks of China, Japan and Korea have chosen to lend us hundreds of billions of dollars in recent years. That has contributed to low rates as much as Fed actions. It won’t go on forever.
© 2004 Edward Lotterman
Chanarambie Consulting, Inc.