The Federal Reserve’s Federal Open Market Committee will meet this week to set monetary policy. The conventional wisdom — which is almost always accurate in this area — is that the FOMC will cut the federal funds interest rate by at least 25 basis points (0.25 percent) and perhaps as much as 50 basis points.
Federal Reserve Board Chairman Alan Greenspan has let it be known that he is still concerned about deflationary pressures in the U.S. economy, and believes that one last rate cut is necessary as an insurance policy to make sure that the burgeoning economic expansion continues.
There is a danger, however, that this rate cut may be one too many, tipping the economy over the edge from beneficial reflation to harmful inflation. Another problem is that if the Fed should come to believe that it has gone too far, it will be very difficult to reverse course because we are moving into a presidential election cycle. Historically, the Fed has avoided making major policy moves during this period, lest it be accused of influencing the economy for political reasons.
If I am right, then the earliest the Fed could begin to tighten to counter an inflationary outbreak won’t be until November of next year, after the election. At that point, the economic cost of a tighter monetary policy may be much greater than if such a policy were implemented earlier.
The Fed may be reasoning that this is the latest point at which it can ease monetary policy further without appearing to favor George W. Bush with a robust economy going into the election. Therefore, it must ease now or risk the chance that the expansion will be nipped in the bud without having the ability to ease further.
I hope the Fed is right. Certainly there are respected economists who agree. My friend Larry Kudlow believes that a robust expansion is now underway and that this will increase the demand for money. Therefore, an additional expansion of the money supply will not be inflationary at this time. Other economists point to the low rate of capacity utilization in the economy — large numbers of unemployed, factories running at half speed — and say that this, too, will prevent inflation from emerging again for at least several quarters.
My concern is that there is a long lag between a Fed action and the first unmistakable signs of its impact. If the Fed eases too much, it could be two years before it starts to show up in the Consumer Price Index. The same is true when the Fed tightens too much. The CPI changes only very slowly in response to changes in monetary policy and is subject to measurement error and forces that may camouflage underlying tends. For example, a drought may temporarily raise food prices or OPEC may jack up oil prices, thus causing the CPI to rise even though monetary policy is tight.
To try and get a handle on the true state of monetary conditions, one has to look beyond the CPI and conventional measures of inflation. One has to look at things like sensitive commodity prices, especially those like gold that are traditional hedges against inflation. Interest rates and the yield curve also provide important information, because long-term rates mainly reflect inflationary expectations while the Fed can only control very short-term rates.
Like the first flowers of spring, there are some very early signs that we have turned the corner and moved past reflation — a compensation for past deflation — and into inflationary territory. Gold prices are up and long-term interest rates are rising. The CPI had its biggest increase in nine months in May and the dollar has fallen on foreign exchange markets. But the signs are not unmistakable. Even economists who share the same general outlook disagree. Some, like David Malpass, think there is still more ground to be made up before reflation tips into inflation. Others, like Brian Wesbury, think inflation has definitely started to reemerge and are urging the Fed to tighten, not ease further.
One argument for allowing a bit of inflation to come out of the closet is that it will help repair corporate balance sheets and restore lost individual wealth. For a time, inflation is very beneficial to businesses because they can raise their prices faster than their costs rise. Thus profits will rise, which will raise stock prices. Consequently, if we are in the early stages of inflation, it is extremely bullish for the stock market. Higher stock prices will improve consumer confidence and encourage business investment. The result could be a booming economy over the next year or two.
Eventually, the Fed will tighten. I just hope that if it waits until late next year, it won’t be too late to prevent another boom-and-bust cycle.