Tuesday and Wednesday's testimony by Greenspan to Congress confirmed that, having for over a year warned us of the approaching peril of deflation, he now realizes that with commodity prices rising for over a year and consumer prices ticking up recently, it is inflation we should fear. The tsunami of monetary growth, loosed on the U.S. economy since 1995 and redoubled after 2001, has finally produced not only a stock market bubble and a housing bubble, which careful government statisticians could safely ignore, but real live inflation in the consumer price index, ignorable no longer. Greenspan is now faced with a dreadful dilemma: he must increase short term interest rates in order to prevent inflation from snowballing as it did in the early 1970s. Yet doing so will cause stock market and house price declines that must inevitably bring the U.S. economic recovery to a shuddering halt, and plunge the U.S. consumer into a nightmare of unpayable credit card, automobile and mortgage debt.
By first ignoring the warning signals in 1996 that the U.S. economy and stock market were overheating, and then using monetary policy as a cure-all for all the ills that have subsequently beset the economy, Greenspan has painted himself into a corner. Far from deflation being a threat, as he claimed implausibly throughout 2003, both the consumer and producer price indexes have now shown inflation rising to the 5-6 percent range.
For Greenspan and Wall Street, this is either a signal of extraordinary economic strength, or a temporary blip. To the Keynesians who now appear to inhabit the Federal Reserve, inflation can only reappear at a time of demand-pull, when industries are running close to capacity and the economy is showing severe signs of overheating. Hence the current situation, with a weakish economy but signs of reawakening inflation, must be a mere temporary aberration. In any case, productivity gains, held up by Greenspan as the Holy Grail since 1997, will ensure that inflation remains subdued this time around.
To monetarists, believers that the only time the Federal Reserve did anything but damage to the U.S. economy was under Paul Volcker in the early 1980s, this is nonsense. If you allow M3 money supply to grow at almost 10 percent per annum for year after year for close to a decade, you will eventually get inflation. That need not necessarily appear in the "demand-pull" pattern, it can also appear through "cost-push" in which the dollar (whose supply is being over-inflated) declines in value against other currencies, while commodity prices set themselves on a determinedly upward trend.
It is thus wrong to suppose that such a persistent rise in input prices will not be reflected in output prices in a recession. If demand is weak, firms are less able to expand margins than in periods of high demand, but they will still raise prices, simply to keep margins at their existing modest levels. Competition from third parties constrains them, but not indefinitely; Chinese and other low labor cost producers are as much constrained by high commodity and energy prices as U.S. producers, maybe more so since they are often less efficient users of material and energy inputs.
Even without rising commodity prices, excess money creation reflects itself in rising prices in another way, the rising prices of monetary assets such as stocks and physical assets such as housing. By convention, these are not explicitly included in price indexes, so politicians can continue to claim low inflation even when their prices are rising rapidly. However, the linkage between money creation and prices does not care about government economists' arbitrary distinctions between what is and what is not a consumer price, it simply works on prices generally, and if interest rates are low it works more fiercely on asset prices than elsewhere. Since 1995, excess money creation has been reflected, first in excessively rising stock prices and more recently in excessively rising house prices. Now at last it is spreading into the parts of the economy that even government economists recognize, and something must be done.
A neutral posture for short term interest rates, in an environment where inflation is around 2.5 to 3 percent and heading upward, would be a federal funds rate of around 4 to 5 percent, compared with the current level of 1 percent. Long term interest rates would then also rise, so that 10 year Treasury bond rates would be around 5.5 to 6 percent, compared with the current 4.4 percent, giving the normal "real" long term interest rate of 3 percent.
However, this would not be enough to kill the resurgent inflation, it would merely stop it accelerating further. To dampen inflation, real interest rates, both long and short term, must rise significantly above their equilibrium long term levels, in order to produce the monetary tightening that reduces inflationary pressure. In other words, it is most unlikely that a Federal Funds rate below 6 percent, or a long term Treasury bond rate below 6.5 to 7 percent, would have any significant inflation-reducing effect.
Greenspan is thus in a similar but significantly worse position than was Federal Reserve chairman Arthur Burns in 1972. The Federal budget deficit has spiraled out of control, and is most unlikely to decline significantly, so fiscal policy can give him no help. Therefore, if he wants to reduce inflation, he must increase the federal funds rate from 1 percent to around 6 percent, and watch the 10 year Treasury bond rate rise from 4.5 percent to close to 7 percent. Needless to say, if he did any such thing, the collapse in the bond, stock and housing markets would be very severe, and the economic side-effects of that collapse would be catastrophic. For example, given the minute capital base and devil-may-care lending policies of the U.S. housing agencies Fannie Mae and Freddie Mac, any such move in interest rates, combined with a sharp decline in housing activity that decimated their fee income, would almost certainly wipe out both entities' capital and cause a crisis in the housing market that would dwarf the savings and loan collapse of 1989-91.
Since Greenspan is most unlikely to choose career and reputation suicide in this way, it is likely that any increase in interest rates will be too little and too late, with the Federal Funds rate probably remaining below 2 percent for the rest of 2004 and into 2005. Inevitably, this continuation for a further substantial period of negative short term and even long term real interest rates, together with the inflationary momentum already built in, will cause the current stirrings of inflation to surge into prominence, with prices rising at a steady 6 to 8 percent per annum by the early part of next year. Just as Burns' reputation was ruined by the inflation of 1973-74, and the deep and prolonged period of economic anomie that followed, so too will Greenspan's reputation be forever tarnished, in the last years of his tenure, by a resurgence of the inflationary dragon that all had thought slain by Paul Volcker in the 1980s.
What a pity, Greenspan will soon be thinking, that he did not resist the seductive charms of monetary expansion, and remain devoted to the path of virtuous monetary restraint. If his monetary conscience is not yet awakening, it surely will be by the end of the year.
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, April 2004) -- details can be found on the Web site greatconservatives.com.
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