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 conditions. 

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 price distortions. 

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 increases. 

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 environment. 

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). 

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