7/20/00 6:25 p.m.
Price Ain't Right at the Fed
Alan Greenspan's departure from the price rule is a policy mistake.

By Victor Canto, La Jolla Economics

lan Greenspan's performance as Fed chairman has been deserving of the Nobel Prize in economics. During his watch, the U.S. inflation rate has declined from the 4 to 6% range to the neighborhood of 2%, and much of his success can be attributed to the adoption of a domestic price rule for guiding monetary policy. The operating procedures of the price rule are quite simple: It assumes that inflation is too much money chasing too few goods.

In the U.S. experience, the price rule has worked quite well. The inflation rate has declined and so have inflationary expectations. The benefits of these policies are fairly obvious: Inflation-induced bracket creep has been reduced, investors' horizons have been lengthened and the U.S. economy is the envy of the rest of the world. While it is true that the Federal Reserve Board has never stated publicly that it is following a price rule, the following statement from Alan Greenspan as part of the conclusion in his testimony today before the U.S. Senate Committee on Banking, Housing and Urban Affairs comes fairly close:

Maximum sustainable growth, as history so amply demonstrates, requires price stability. Irrespective of the complexities of economic change, our primary goal is to find those policies that best contribute to a noninflationary environment and hence to growth. The Federal Reserve, I trust, will always remain vigilant in pursuit of that goal.

So, if the Fed chairman believes the above statement and follows the price rule, why is the inflation rate increasing? Is Greenspan deviating from the price rule, and if so, why? He provides the answer to these questions in his concluding remarks:

The last decade has been a remarkable period of expansion for our economy. Federal Reserve policy through this period has been required to react to a constantly evolving set of economic forces, often at variance with historical relationships, changing federal funds rates when events appeared to threaten our prosperity, and refraining from action when that appeared warranted. Early in the expansion, for example, we kept rates unusually low for an extended period, when financial sector fragility held back the economy. Most recently we have needed to raise rates to relatively high levels in real terms in response to the side effects of accelerating growth and related demand-supply imbalances. Variations in the stance of policy — or keeping it the same — in response to evolving forces are made in the framework of an unchanging objective — to foster as best we can those financial conditions most likely to promote sustained economic expansion at the highest rate possible.

In essence, the chairman is saying he believes that the Fed is smart enough to anticipate the changes in demand for money. Assuming the Fed can do so, the next step is to change the quantity of money in anticipation of the expected change in demand. If the Fed is correct in its forecast, the money market will remain balanced and the inflation rate will not rise. However, to the extent that the Fed forecast is not correct, the inflation rate will deviate from its target.

Whether the Fed can correctly forecast the changes in demand depends on the quality of its macro-model. One can have reservations about the Fed model because it is unduly influenced by the Phillips curve. It believes that strong growth produces rising inflationary pressures. That's a fallacy. If inflation is a monetary phenomena, then inflation is nothing more than too much money chasing too few goods. Thus, strong growth reflects an abundance of goods and a shortage of money — that is deflationary not inflationary. The data clearly support our views. The spike in inflation during the late 1980s and early 1990s was accompanied by slow growth. Similarly the decline in the inflation rate experienced during the '90s took place when the economy grew faster than the Fed expected.

Thus, the fact that the inflation rate was above its target rate in the late 1980s and is now rising suggests that the Fed forecast during both instances was not accurate. Looking back, the rise in inflation during the late '80s and early '90s was accompanied by an economic slowdown. We attribute the slowdown to the Bush tax-rate increase. The slower growth led to a decline in the demand for money and to a higher inflation rate.

What About Now?
The present economy is all Y2K related. During 1999, the Fed was worried about the century date change resulting in a surge in demand for cash. They responded by increasing the quantity of greenbacks circulating in the economy. However, they were very smart. The increase in greenbacks was temporary and had a self-extinguishing mechanism. All the liquidity was provided through REPO agreements with the banks. When January came around, the liquidity was withdrawn from the system. A cautious Fed provided more liquidity than necessary, and the inflation rate rose somewhat.

The century date change had a real effect on the economy. The economy's growth rate accelerated in the second half of last year. And the relatively robust expansion was little surprise. Even if one didn't believe that Y2K would be a problem, there was no reason not to "buy" some insurance by stacking up on certain items. Using this line of reasoning, one would expect businesses and individuals to increase their purchases as the millennium approached. A casual empirical analysis supports this contention.

For example, Del Monte reported a surge in sales during the fourth quarter. For consumers, there is very little cost in buying additional canned foods, storing them and consuming them the rest of the year. And, the point is, Del Monte's sales are likely to be below trend this year. For computers, the story is the opposite. The Y2K fear led to a slowdown in the purchases of computers as consumers waited until after the century date to purchase — a sensible strategy. The implication was a slowdown in computer sales in the later part of 1999, with a strong first half of 2000. If the Y2K timing issue is as strong as it appears, the question is will the economy, on net, behave like canned pineapples or computers? Based on the performance of the economy during the second half, that question can be answered.

What's surprising is that Alan Greenspan, who was so good about adjusting liquidity in advance of the century date change, hasn't extended his analysis to the real economy. The opening line of his recent Humphrey-Hawkins testimony is evidence that he didn't see the impact of Y2K on the timing of real GDP. "There is little evidence that the American economy, which grew more than 4% in 1999 and surged forward at an even faster pace in the second half of the year, is slowing appreciably," he said.

The man who worried that the century date change would affect the demand for cash did not extend his analysis to the demand for goods and services. The acceleration in the rate of real GDP growth is easily explained in terms of Y2K. If this hypothesis is correct, all that happened was that the economy changed the timing of production. Some of this year's production shifted into 1999. Given the growth trend in the economy, any temporary increase would represent a temporary reduction the following year. Furthermore, if changing the timing were costly, one would like to have the shift as close as possible to the event. Thus, the acceleration would be stronger the closer we got to 2000; similarly the economy would be weaker the first half of the year (calculating the Y2K year-over-year income shift at approximately 1%).

Fed Up
Taken at face value, the Fed hasn't been all that successful in slowing the economy. The major effect of the Fed policy has been to reduce banking system credit, increase uncertainty, and reduce the demand for money. The net effects of these policies have been to lower valuations and increase the inflation rate. Viewed this way, Greenspan does not deserve a good report card on his recent handling of the economy.

The departure from the price rule is a policy mistake. The beauty of the price rule is that it identifies any imbalances irrespective of their source. Whenever the inflation rate rises, like now, it is because there is too much money circulating in the economy. The proper policy response is to withdraw the money. Looking forward, there's reason to be quite bullish. As the economy slows down to the 3% to 3.5% real GDP growth rate, the Fed will not worry about imbalances and thus will not try to regulate the real economy. It will focus only on price stability.

The inflation rate should slow down to the 2% range in the next year, and the economy and financial markets will continue their strong performance.