March 30, 2005
Remember the movie where Bill Murray had to relive
Groundhog Day until he finally
got it right. I am beginning to
feel the same way about Federal Reserve policy, but they are not yet close
to getting it right.
Sometime after I finished my formal economic education,
some economists began to develop what has become known as macrodynamics.
This not only discusses how markets and economies interact with each
other, but also how time enters into the process of resolving economic
The ideal economic outcome no longer is the highest
utilization of resources at a point in time but the best sustainable high
rate of growth with high resource utilization over time. Not surprisingly, this process indicates that attempts to
push unemployment rates “too low”, as in the 1960s, led to inflation
that ultimately resulted in growth instability.
Clearly, there are benefits in merely describing how
economies behave over time. However,
some of the power of this technique is to argue what policies should be
pursued to smooth out the rough periods of economic activity and avoid the
excesses that lead to those growth instabilities (I’m avoiding the
recession word because it frightens too many people).
When economic growth is inadequate, as it clearly was
early this decade, policies should provide substantial boosts to get growth
slightly above sustainable rates. Then
some slowing in the impulse of those policies is needed to glide the economy
onto that growth path before rising resource utilization begins to create
We are dealing with human behavior, so no one can
perfectly administer this policy. However,
the form of policy is relatively clear.
Just as a rocket needs maximum thrust to get off earth and then makes
small maneuvers as it approaches the desired orbit to attain the desired
speed, the same is true of policy.
Early in this decade, policy was on target.
Massive tax cuts and over-night interest rates well below the rate of
inflation injected massive boosts to the system.
Finally, in the four quarters of 2003, growth reached 4.3 percent,
clearly above the sustainable growth target.
Because inflation appeared to be slowing to a low of just over 1
percent for the core by the end of that year, there appeared to be no reason
to slow the heavy doses.
However, the stimuli generated serious commodity price
surges in the spring of 2004. The
Fed was slow on the uptake, while the Treasury saw no reason to be involved
in deficit reduction (and still does not).
The result was a shift from deflation concerns to a modest
inflationary sizzle in commodities.
Furthermore, the Fed had a problem.
Overnight rates had declined so far that a major slowing in the
monetary thrust would require percentage changes in interest rates that
might shock the monetary system. Thus, the Fed established a “measured” pace for its rate
The growth rate did slow slightly, to 3.9 percent in
the latest four quarters. However,
this is still above that sustainable rate, as the rise in utilization rates
of resources clearly shows. More
significantly, commodity inflation began to spill into housing inflation
(which already had become a problem in other parts of the world).
We probably cannot maintain a stable growth path with
unsustainable price growth, even in assets.
Indeed, we may have proved that when the stock market bubble burst as
the century began. And double
digit price gains for housing clearly are not sustainable in a low inflation
We know what the Fed has done-a quarter point increase
at every meeting. What should
they have done?
They might have started with a quarter point to signal a policy shift and then stepped up quickly to a half point change the next meeting, a full point the meeting after and then began to slow the rate gains as overnight money approached sustainable inflation adjusted rates.
Instead, they are wondering why the simmering inflation
pot is beginning to boil. They
are signaling that they may need to be more aggressive to insure inflation
does not become a part of economic decisions.
(With 236,000 open contracts in crude petroleum and nearly 9 percent
of all new houses being resold without ever being occupied, inflation fears
already have motivated some people).
When I taught business cycles decades ago, I always
declared that the Fed began with baby steps and ended its moves with a bang.
Instead, they should have started their moves with a bang and ended
with a whimper.
Oh well, this policy day started more promising than the last, but I’m beginning to hear Cher in the background (the music that indicated Bill Murray needed to try again).