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May
9, 2003, 7:00 a.m.
The Fed’s Deflation
Greenspan
& Co. can take the blame. They can also fix the problem.
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he Fed hinted
at deflation at its policy meeting this week. Is it the case? Will it
be the case?
The Federal Reserve’s
preferred measure of inflation, the rate of change of the Personal Consumption
Index, is running at around 1 percent. However, the measurement errors
in the index may be on the order of 1 percent. So the case for deflation
can easily be made.
More, given the
economic recovery, albeit a weak one, it follows that real interest rates
must be rising. But they're not. The current decline in Treasury-bill
yields on the face of a recovering economy is prima facie evidence of
deflation.
Looking at the behavior
of the monetary base, as reported by the Saint Louis Fed, the case for
deflation is, in fact, a strong one. Since February of this year the monetary
base has been essentially flat. Again, given that we're in a recovery,
if the velocity of the base has declined then we should expect
a decline in Treasury-bill yields. And that is exactly what happened.
The decline in velocity (or the speed at which money is changing hands
in the economy), given the current low inflation, is an indication of
rising deflationary pressures.
Larry
Kudlow is right. The Fed needs to increase the quantity of money circulating
in the economy.
In theory there
are more ways than one to control inflation/deflation and interest rates.
Many supply-siders correctly prefer controlling the level of prices by
using the domestic price rule. Simply put, the level of prices provides
a signal for action to the Fed. For example, whenever prices fall there
is too little money in the system. Falling prices signal the need to increase
the quantity of money. And this is easily done by the Federal Reserve
through an open market operation (i.e., the Fed buys bonds in the open
market, sending cash into the economy).
The monetary gospel
posits a negative relationship between the turnover rate (i.e., velocity
of money) and interest rates. Thus, by controlling interest rates the
Fed can control the quantity of money in circulation. However, what about
the converse? The Fed could control inflation and interest rates by controlling
the quantity of money in the economy.
The data make a
compelling case that we are on the verge of deflation. While no one can
hold Alan Greenspan and the Federal Reserve solely responsible for the
economic slowdown, they certainly deserve some of the blame. More, the
Fed is solely responsible for the threat of deflation today. If
inflation/deflation is a monetary phenomenon, there is a simple solution
to the deflation threat: PRINT MORE MONEY.
Alan Greenspan is
not doing as good of a job as he did during the 1990s.
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