Tuesday, July 8, 2008

The Fed and Lessons of History

Gerard Baker in a Timesonline article wrote an interesting piece on the Fed and its critics linking them to a dispute over their views of the proper historic precedent for policy.

You can find the article by cutting and pasting this address to your browser:

While Bernanke may be swayed by his knowledge of the Great Depression, there is no evidence that has has not learned the lesson of the last oil shock in the early 1970s.

The Fed is monotone on the issue of anchoring inflation expectations I don't see how anyone can think the Fed is unaware of the inflation risk from oil.

Maybe the real history lesson here is not about which lesson to learn- but who learned it.

The other statement about history is that it is a recollection written by the winners. In the case of inflation, history is written by the survivors. One point is that those who have seen this sort of inflation before know how dangerous it is.
Survivors remember the Fed's obfuscatory rhetoric from last time. So once again the Fed is at it and not singularly focused on inflation due to the banking sector turmoil.

But does that make the Fed an inflationist? I don't think so.

Rising oil prices make oil consumers poorer. They drain spending power and this happening to all countries around the world. Monies are being transferred to oil producer nations who generally have a higher propensity to save. So high oil prices are a growth-reducing event.. With the US economy already beset with financial turmoil, falling house prices and contracting lending the Fed wants to be wary of yet another contractionary event.

But the Fed has cut rates and inflation is rising so inflation survivors are wary- they have seen 'this' before. Or have they?

They have not. Money growth is weak. M2 and MZM money growth rates are negative over 4-weeks and mild to negative over three months. The Fed is not fertilizing inflation. Moreover the headline rise in inflation is unavoidable. To hold the headline rate 'in target' at all times would imply pushing other prices down as oil prices rose -a very painful approach and one THIS economy surely could not stand and continue to grow.

So for a while the headline inflation will continue to be excessive. That is no black mark on th central bank. As long as oil shocks continue to boost oil prices to higher and higher levels this configuration will continue: headline inflation will exceed core inflation. Once oil reaches a plateau or backs off then we will see core and headline inflation come together again. If the central bank has done its job they will converge at a still moderate level. That is why the Fed is working to contain CORE INFLATION and that is the point of it.

The Fed is doing nothing to moderate the rise in relative oil prices as the money growth figures show us. The Fed is guarding against inflation transmission by forcing the high oil price to push other prices down. By the way, while US interest rates are lower than the ECB's US money and credit growth still are much slower in the US than in Europe. Even more than the ECB, the Fed is not printing extra month to 'inflate' away 'the problem' as Aurthur F Burns did in the early 1970s.

So why aren't core prices falling if the Fed is not accomodating the oil price spurt? It's because the Fed's powers work over time. In the short run people do things to maintain spending (dis-save or sell assets etc) and that delays at the impact on nonoil prices. But as long as the Fed does not accommodate inflation, the rise in oil prices will not be inflationary but instead will become a hike in the relative price of oil and that will force great and painful change on the economy. The inflationist central banks try, in folly, to spare that pain. The Fed is not on that path.

But this Fed's head is Ben Bernanke and he knows the risks. He read the history - all of history. He even wrote some it... He is no Arthur F Burns. At some point even inflation survivors will have to give him his due.