April 14, 2004

Both the physicist and economist sometimes are solving similar problems.  The physicist wants to know precisely how long the rocket must burn fuel to glide into a sustainable orbit.  The economist wants to know how long to pursue a stimulative policy until a sustainable growth path has been achieved by the economy.

Of course, the physicist has the easier problem.  The gravitational pool is precise, basically known, and the control over policy (the burn of the rocket fuel) is virtually precise.  Indeed, the sustainable orbit is known with virtual certainty as well. 

We economists must guess at the sustainable path, which might have changed since the last time we sought it.  Our policy controls (money growth, tax changes, and spending programs) are buffeted by many factors that have little to do with optimum economic performance. 

Most importantly, the response to these policies depends upon reactions by humans.  As Nobel Laureate Robert Lucas argued, all policy reactions are unique because this time people not only know the policy and how they acted last time, but also how the economy’s reaction differed from what they expected. 

Thus, a tax cut this time gets a different response from last time because we did not know what would happen from our response last time.  This time we do, and will behave differently because of that knowledge. 

By the way, Lucas made a mistake by surmising that uniqueness meant uncertainty.  Perhaps there is a range of results that we will never know precisely (how I envy those physicists with their known physical properties).  Yet, we should know enough to plead good policy. 

Which brings me to the subject of this column.  When should the Federal Reserve slow the rocket burn to seek the sustainable growth path. 

Administration economists seem to think we can keep interest rates below equilibrium until signs develop that we have overshot.  In other words, if no inflation surfaces, then we must not be there yet. 

That is wrong.  (Secretly, they probably want interest rates unchanged until the people have spoken in November, but I never knew that the correct policy was one that coincided with the political calendar.)

Inflation’s response to policy works through many channels, such as currency values, asset prices, material costs, labor contracts, construction costs, etc. that do not surface in identifiable consumer prices for many months.  Just as you know your house is in danger when you spot a termite, inflation already is embedded by the time the popular inflation measures are accelerating. 

Indeed, two of my measures of future inflation, the inverse of the dollar’s value and the prices of crude materials other than food and energy, have been soaring for many months.  The dollar has rallied recently (to show that precision is not possible in these forecasting devices) but remains well below previous year values. 

I might also argue that real estate prices are growing far beyond what reasonable returns provided by those assets would predict. 

Because job growth and its resulting increase in earnings has been so hard to generate in this recovery, I have agreed with the Federal Reserve’s patience in maintaining their low interest rate policy.  We need the wage growth to be assured that economic expansion will persist once the tax injections cease. 

(By the way, the President’s desire to make those tax injections permanent is the equivalent of having the doctor continue to give you medicine even after you are well.  It is bad policy and should be resisted, or are we so greedy for what comes to us individually that we no longer care what is needed collectively?)

Would I object if the Federal Reserve remained patient until they were assured that a job number that was surprisingly strong but was not accompanied by surging earnings picked up those earnings in later months?  No I would not. 

However, if another few months of above trend job growth developed with expanding hours and rising hourly earning, then I would know that politics, not economics, is piloting our policy.  And we will surely miss that sustainable growth path.  How does the inflationary recession of late 2006 sound?

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