This Federal Reserve rate-hiking exercise — which over the past two years has seen the overnight fed funds rate target rise from 1 percent to 5.25 percent in quarter-point moves at 17 consecutive policy meetings — has sparked an unusual degree of controversy and debate among conservative economists who operate under the supply-side moniker. Supply-siders generally agree that the Fed’s primary mission is to pursue price stability by stabilizing the value of the unit of account, and look to market-price indicators such as commodities and the dollar’s foreign-exchange value to gauge monetary-policy performance. In the current episode, however, supply-siders have split over the degree to which the Fed is confronting a potentially serious inflation breakout that must be subdued with higher rates. Some are even suggesting that higher rates affected through the Fed’s rate-targeting mechanism are themselves the culprit for the intensified warning signs of rising inflationary influences.
#ad#Up to a point, a skeptical view of this monetary-policy episode is certainly understandable: The Fed has a well-earned reputation for overshoot. More often than not, Fed tightening episodes have ended badly, with the central bank pushing rates up to economy-punishing levels. And there’s little question that the Fed’s rate-targeting regime is a crude and inefficient mechanism for realizing what should be the Fed’s first objective — balancing the supply and demand for dollar liquidity so as to maintain stable dollar purchasing power.
Rate-targeting is a product of the Fed’s highly flawed Keynesian conception of its policy task: Higher rates slow growth and prevent inflationary “overheating,” while lower rates encourage borrowing and provide an economic lift. Under this paradigm, all too frequently the Fed finds itself conducting policy to correct for its previous error. The current tightening campaign, in fact, is a response to the Fed’s overly aggressive easing of earlier this decade, which itself was a response to the deflationary rate hikes of 1999-2000 that ultimately threw the economy into recession.
Rather than constantly chasing its tail in an attempt to fine tune the economy, the Fed should adopt a policy rule under which it would add and withdraw liquidity so as to directly target a sensitive market price — such as gold — at a level consistent with a stable price level. But be that as it may, for all its deficiencies and shortcomings, rate-targeting in the final analysis produces the intended results: Higher rates tighten the availability of liquidity, leading to a higher real value for the dollar; lower rates create easier monetary conditions, softening the dollar and fostering higher inflation if a sustained liquidity excess is allowed to develop.
In the current exercise, part of the confusion arises from the fact that the Fed began hiking rates from such an extraordinarily easy starting point. Under ordinary circumstances, a total rate increase of more than 4 percentage points would have yielded an unmistakably tight policy stance with the expected consequences — falling commodity prices, a stronger dollar, and widening credit spreads. In the present environment, however, all available evidence suggests that after lifting the funds rate by a total of 4.25 percent, the Fed has yet to reach monetary neutrality.
The gap between nominal GDP and the funds rate — one measure of the relative ease or tightness of policy — remains at its highest levels since the 1970s on the basis of a four-quarter moving average. It is not terribly surprising, then, that sensitive market-price indicators show the Fed is still in an inflation-biased stance. The most monetary of all commodities, gold, has dropped about $100 from its twenty-five-year high of around $720 in early May. But it still remains nearly 80 percent above its 10-year moving average, pointing to the continued likelihood of higher inflation ahead.
For those who think the Fed can now safely retreat to the sidelines, or those who insist that higher rates are actually exacerbating the problem, developments of recent months should have provided a wakeup call.
In late April, Fed chairman Ben Bernanke gave a dovish review of the policy outlook on Capitol Hill, suggesting that the Fed could pause in the tightening process even if inflation risks were not contained. His testimony was widely interpreted as giving a higher priority to protecting growth than to fighting inflation. In response, commodities soared and the dollar tanked in what amounted to a thumbs-down on the Fed’s credibility.
After licking his wounds and offering an apparent mea culpa to CNBC anchor Maria Bartiromo, Bernanke appeared eager to demonstrate that he had learned his lesson. The statement following the Fed’s May 10 policy meeting was more hawkish than expected. A series of signals from inside the Fed pointing to this perspective culminated in an early-June speech by Bernanke, in which he suggested that recently elevated core inflation readings were “unwelcome” and that re-anchoring inflation expectations was a high priority. Gold, which had already fallen about $80 from its highs, fell another $80 over the next several days to a range around $560.
Prior to Bernanke’s speech, futures markets put the odds of the Fed lifting the funds rate from 5 percent to 5.25 percent at its June 29 meeting at less than 50 percent. In short order, futures moved not only to fully price a late-June rate hike, but also sharply upped the odds on the rate going to 5.5 percent in August. The response of market-price indicators to these shifting expectations, with commodity prices dropping and the dollar rallying, was a clear signal from the market that this would be the correct course. One might expect a more expectations-sensitive Fed to agree.
However, when the Fed followed through and put the rate at 5.25 percent late last month, it released a statement opening the door to a potential pause in August, offering up the long-discredited rationale that a moderation in growth “should help to limit inflation pressures.” In a snap, gold was on its way back above $600, the CRB spot commodities index (which does not include oil or gold) shot to new record highs, and the dollar slumped back toward its early-June levels on foreign-exchange markets.
This amounts to a clear-cut message to the Fed that its task remains incomplete. It also should stand as confirmation to supply-siders that inflation risks remain at heightened levels and that the Fed’s management of the fed funds target is fundamental to the prospects for restoring policy equilibrium without committing serious inflation error.
– David Gitlitz is chief economist for TrendMacrolytics.