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My Two Cents

Some Thoughts on the Fed

Chris Farrell Mar 15, 2008

My latest musing on the economy.

On Mar. 7, when the government reported a loss of 63,000 nonfarm jobs in February (with a decline of 101,000 private-sector jobs), it seemed that both Wall Street and Main Street decided all at once that, yes, the U.S. economy is in recession, or well on its way into one. That’s why there’s little doubt among the financial cognoscenti that when Federal Reserve policymakers meet on Mar. 18 the central bank will cut its benchmark interest rate again, perhaps by half a percentage point, to 2.5%.

If so, the Fed will have slashed its target rate by 2.75% since last August. But while the central bank’s concerted policy of monetary easing is aimed squarely at forestalling a recession and lending a hand to the shaken financial system, other dangers lurk.

Inflation as Bailout

Here’s the rub: While the Fed fights recessionary forces, inflation is gathering momentum. “It’s the ‘Fed to the rescue,'” says Jonathan Guyton, certified financial planner at Cornerstone Wealth Advisors in Edina, Minn. “But I’m worried that their actions will set up a real inflation problem a year from now.”

Maybe sooner. The headline consumer price index and producer price index figures are already running at rates double to quadruple above the Fed’s target range for inflation. The dollar has plunged to a record low against the euro, to a 12-year low against the Japanese yen, and is now nearly at par with the Swiss franc. After adjusting for inflation and trade flows, the dollar is off some 20% since peaking in early 2002, according to Mark Zandi, chief economist at Moody’s Economy.com (MCO). The rise in the cost of imports spurred by the decline in the dollar is putting upward pressure on U.S. prices.

And the ripples are being felt in other markets as well. Gold, the hoary “currency” hedge against inflation, is trading around $1,000 an ounce. Oil, wheat, and other commodities are skyrocketing.

“So far I think all the tea leaves point to inflation as the bailout: thus, the run in oil, gold, and nondollar currencies all makes some sense,” writes Bernard Picchi, a veteran oil industry analyst with Wall Street Access. “Very scary nonetheless.”

A 1970s “Malaise”

The dollar’s decline echoes some frightening moments in the recent past. In Secrets of the Temple, William Greider’s magisterial history of the Fed, he recounts how global investors reacted to President Jimmy Carter’s attempt to address inflation with his “malaise” speech on July 14, 1979. “The American dollar, bought and sold daily in huge volumes on the currency exchange, had been sliding in value, almost every day. This meant currency traders–banks, multinational corporations, wealthy investors, perhaps even other governments–expected the U.S. dollar to continue to lose its value in the coming weeks and months, and they, therefore, found it safer to hold their wealth in other currencies,” writes Greider. “Roughly translated, the dollar’s steady decline amounted to an inflation forecast.”

Back in the days of disco, the opinion of the international financial community was that American inflation would get worse–a judgment that proved right. Shades of today’s wobbly dollar?

Indeed, investment manager and financial writer John Mauldin invokes the days of malaise in commenting about Bernanke’s zealous course of reviving the economy and ignoring inflation: “Won’t that guarantee a repeat of the ’70s and require a new Volcker to come in and cause a deep recession to bring inflation back down?” he asks. (For those who don’t remember the 1970s, either because they weren’t old enough or, well, because they were the 1970s, Paul Volcker was Federal Reserve chairman from 1979 to 1987.)

Bring back Volcker? Is the inflation problem and international financial crisis that bad? Let’s hope not. Still, the risk facing the U.S. economy is that investors lose confidence in Ben Bernanke.

Lessons from the Great Stagflation

Let’s take a trip back in time to see why. During the Great Stagflation of the 1970s, the Fed talked a good game against inflation. But in reality Fed Chairman Arthur Burns and his successor, G. William Miller, ran inept monetary policies that stoked the fires of inflation. By the end of the 1970s the Fed had no credibility internationally or domestically as an inflation-fighting central bank.

The numbers are enough to make anyone wince. For instance, during the 1973-74 bear market, stocks plunged by more than 40% before touching bottom and the bond market suffered a 35% loss–and the cost of living jumped some 20%.

It got worse. Inflation seemed to spiral ever higher. Prices kept going up–at the gas pump, the supermarket, and the car dealership. The dollar spiraled lower and gold surged to record levels. Nothing seemed to stem the inflationary tide. Wall Street treated Fed Chairman Miller, President Carter’s appointee, as a joke. So Carter replaced Miller with Volcker, the extremely independent president of the Federal Reserve Bank of New York. (Miller was moved to the Treasury Dept.)

Volcker was determined to crush deeply ingrained expectations of ever-higher inflation among consumers, business, investors, and the international community. He stomped on the monetary brakes. Interest rates skyrocketed from about 11% in 1979 to 17% in April, 1980, and reached 20% in early 1981.The economy went through two contractions, including the worst downturn since the Great Depression. Millions of workers lost their jobs. Farmers went bankrupt in droves.

But the strong medicine had its intended effect: Inflation came down. Volcker’s successor, Alan Greenspan, continued the fight and the consumer price index came down from a peak of 14% in 1980 to the 2%-or-so range, until now.

A Little Tolerance Goes a Long Way

This history suggests why we don’t need a Volcker–yet. It’s important to remember that the stagflation of 2008 is nothing compared to the stagflation of the ’70s. What’s more, Volcker predecessor Miller, a former business executive, was in way over his head at the helm of the Fed. In sharp contrast, Bernanke is one of the nation’s leading scholars of the central bank, steeped in its traditions and well aware of its monetary mistakes.

Still, what the past suggests is that once the systemic financial crisis calms down, Bernanke and his colleagues will have to turn their attention toward combating inflation even if the economy continues to drift lower. It’s one thing to tolerate a burst of inflation in order to manage a crisis; it’s another to let inflation take root to wreak havoc for several years. After all, the lesson of the 1970s is that once inflation expectations get ingrained, it’s a tough, painful habit to break.

We’re not there yet. Let’s hope we don’t have to call Volcker–or his hard-nosed policy prescriptions–out of retirement, either.

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