The Federal Reserve’s policy-making Open Market Committee meets Tuesday for the last time in 2007. It faces harder tradeoffs than any time in many years. Whatever the FOMC decides, it will be years before the success or failure of its action is clear.
General opinion seems to be that the FOMC will further increase the money supply to lower short-term interest rates.
Many commentators use phrases like “the Fed will have no choice but to lower interest rates.” This perpetuates the misunderstanding that the Fed is broadly able to cure economic ills and that there are no drawbacks to hefty increases in the money supply.
The economy obviously is slowing. Keynesian theory, which millions learned in college economics courses and remains the dominant mindset for the media and Wall Street, prescribes increasing the money supply when an economy slides into recession. That is the root of the widely held view that the Fed “has to” pump even more liquidity into the economy.
It ignores history, however. Keynesian thought dominated policy in virtually all industrialized countries in the 1960s and 1970s. Its naive application caused the “stagflation” of the late 1970s, when both inflation and unemployment were high and rising in North America and Europe while output stagnated.
All that painful history seems forgotten by those who argue the Fed “has to” create more money.
Yes, Keynesian ideas aside, the critical role of a central bank is to be a “lender of last resort” to troubled financial institutions during financial panics. And yes, perhaps there are banks that might fail and create chaos without continued Fed money creation. Fed officials know more than the general public.
The perils of more liquidity are real, however. The first danger is simple inflation resulting from too much money, as when prices tripled in the 15 years between 1967 and 1982.
Oil prices remain high, food prices are rising and “core inflation” itself, with these two categories factored out, has risen. The fact that we have had 15 years of low inflation does not mean it is defunct.
The other danger is of further rapid declines in the price of the U.S. dollar against other currencies. A cheaper dollar has boosted U.S. exports sharply in recent months and is cutting imports. But a precipitous slide would stoke inflation and cause foreign investors to bail out of U.S. financial markets, driving up interest rates.
These dangers, largely ignored by U.S. media, are real. There are rocks on both sides of the narrow channel down which the Fed must steer. Moreover, whatever action it takes will be only a palliative for current economic problems and not a solution. There is no putting Humpty Dumpty together again. Making it through these monetary straits is no sure cure for deeper problems of bad mortgages, bad securities and a decade of unsustainable fiscal policies.
© 2007 Edward Lotterman
Chanarambie Consulting, Inc.