OPINION:
Though views vary on the present health of the U.S. economy, the Federal Reserve has been fairly consistent with its contention that a slowdown would help both it and the consumer by keeping pricing pressures at bay.
While Fed Chairman Ben Bernanke cited the weak dollar and commodities as inflation indicators in his latest speech, he reiterated his oft-stated view that too much growth can lead to higher prices, so the Fed must “guide the economy toward sustainable growth without inflation.”
In making the above statement, Mr. Bernanke is suggesting to the extent the Fed can engineer slightly higher unemployment and what he terms lower “resource utilization,” this will reveal itself through a fall in the prices of consumer goods.
Seeking to move inventories suddenly less attractive to more careful consumers, businesses will lower prices on all manner of products such that government measures of inflation will be more quiescent. So while a less vibrant economy would hurt workers and businesses of all stripes, the silver lining within would be lower inflation.
The Fed’s demand-side inflation model makes sense at first glance. But looked at more critically, its assumptions prove wanting. Forgotten here is that supply is by definition demand, and as economic actors trade products for products, lower economic growth will very certainly reduce the supply in the U.S. economy.
For consumer prices, this means a slowing economy will show up in the form of lower work output and lower production. Flagging demand for consumer goods will be met by less supply; meaning the impact on the broad price level will be zero. Say’s Law holds true.
Importantly, empirical evidence suggests economic slowdowns correlate far more with rising rather than falling prices. From 1965 to 1982, the U.S. economy experienced no less than four recessions, but the time in question is far more notable as an inflationary era as opposed to a period when prices fell.
Indeed, as the 1960s ended, investors increasingly questioned the U.S. commitment to the dollar, and inflation crept into the economic picture. With the Bretton Woods system of fixed exchange rates tenuous at best, CPI inflation hit 4.7 percent by December 1968. When President Nixon completely severed the dollar-gold link more than two years later, the inflationary floodgates opened.
By the end of the recession-riddled ’70s inflation was hardly tame given record highs in the price of gold, while the federal government’s consumer price index (CPI) had risen all the way to 13.3 percent. Far from putting a damper on pricing pressures, the economic malaise of three decades past led to a big drop in dollar demand and in lockstep with skyrocketing prices. Inflation, as always, was monetary in nature.
Conversely, the 1980s ushered in tax cuts and further deregulation that stimulated the very economic growth that soaked up the excess liquidity created in the ’70s. Ironically enough, though that growth in the Fed’s monetary base in the ’70s mirrored base growth in the ’80s, the dollar strengthened as a strong economy and a renewed commitment to sound money killed off inflationary pressures.
Two decades of economic growth (interrupted by a relatively shallow recession in the early 1990s) ensued, and inflation, contrary to the Fed model, became virtually nonexistent. Gold fell to a modern, arguably deflationary low of $250 per ounce, and CPI inflation was well below the double-digit territory of the ’70s — hitting 2.7 percent by the end of the millennium.
The experience of the ’70s tells us that a slower economy will in isolation do nothing to reduce inflationary pressures. But, as evidenced by the power of a weak, inflationary dollar to induce recessions, reversal of our weak-dollar policy will bolster what many deem a faltering economy today.
With the dollar now down against all manner of foreign currencies, and gold at record highs again, the Fed needs to act to avoid a replay of the ’70s. It should float the fed funds rate, while targeting a lower price of gold. Importantly, the introduction of a market-price rule would likely force the Fed to increase, rather than cut dollar liquidity so great would demand be for a suddenly credible greenback.
So rather than count on economic weakness to solve a monetary problem, the Fed needs to look inward and not just arrest the dollar’s fall but strengthen it. The latter will solve the inflation problem, while sparking a resuscitation of economic spirits.
John Tamny is editor of RealClearMarkets, and a senior economist for H.C. Wainwright Economics.
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