December 24, 2003
In dealing with policy issues, economic forecasters sometimes must consider the difference between what ought to be done and what will be done.
Before the December 9 meeting, the Open Market Committee of the Federal Reserve System appeared to be doing what ought to be done. The economy could not generate jobs and inflationary pressures were continuing to diminish. For example, the consumer price index less food and energy had slowed from a gain of 1.7 percent over previous year levels in the spring to only 1.2 percent by the end of summer.
Few economists were arguing against a policy that held short term interest rates well below normal (for prevailing economic conditions) in order to stimulate economic activity. A negative real short term interest rate (market rate less the above mentioned core inflation rate) is not normal. However, neither was the growth of employment nor of the economy.
The tide is now beginning to change. Economic growth was the highest in 20 years during the summer. Employment has been growing for four months, although the average over those months remains less than the normal new entrants into the labor force.
Of equal significance are the prospects for inflation. In October, the core rate rose slightly to 1.3 percent above previous year levels. In the past three months, that inflation rate has increased at a 1.5 percent compound annual rate.
These are not dramatic gains. Indeed, they are largely consistent with stable rates of inflation, something most economists would applaud. However, they no longer are consistent with the concern that falling prices are a greater risk than rising prices.
Moreover, a set of inflation indicators I use has turned positive. Sensitive crude prices other than food and energy have been increasing about 3 percent per month over the past three months. The dollar has fallen to new lows against the euro while the broader dollar index adjusted for trade patterns has declined by almost 10 percent in the past year.
Farm prices ended a five year rural recession in the eastern U.S. by climbing 20 percent in the past year. Oil prices remain above $30 per barrel while natural gas prices hover near $5 per thousand cubic feet. These prices are volatile but if they consistently trend higher, they cannot be excluded from inflationary concerns.
While mostly reflecting the dollar and currency uncertainties, gold prices have crossed $400 per ounce, a large double digit rise in the past year.
To be sure, one of my inflation indicators, the cost of producing goods, is the most negative from previous year levels in the past twenty years. But profits are rising (operating profits less taxes are up 33 percent from the previous year), and companies can now put the additional funds to work creating more opportunities (and jobs).
Still, the argument that price declines are more likely than price increases no longer is creditworthy. To continue to claim such will only undermine the credibility of Federal Reserve pronouncements.
But this creates a dilemma. The Fed has said that it will persist in subsidizing short term interest rates for a considerable period of time. If they change their language about the inflation threat on December 9, the markets will view their definition of "considerable" as relatively short. That could hamper policy in the future.
When economic growth was not translating into job growth, the economic expansion remained at risk. Economists wondered if the economic patient could sustain growth once all the tax reductions and mortgage refinancing gains had been absorbed. With growing profits beginning to be translated into capital spending and with wage growth beginning to overtake the growth in consumer spending, this expansion no longer needs all the stimulus that was so necessary only a few months ago.
Indeed, the goal of the Federal Reserve must be the attainment of the maximum sustainable non-inflationary growth that can be achieved. To do that, they will need to remove interest rate subsidies before unemployment has reached more desirable low levels. Otherwise, economic growth will overshoot its target and begin to create inflation, leading to expansion-ending distortions a bit further down the road.
I do not think that the Federal Reserve ought to reduce its interest rate subsidies at the current time. I remain concerned that bank loan activity is not sufficiently robust to support sustainable growth. But the Fed ought to begin preparing us for the time when the elimination of interest rate subsidies will be economically prudent.