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Press Release

    Deflationary Recession

    11/14/2001

    Copley News Service, 11/14/2001

    The Federal Reserve Board has been keeping monetary policy too tight and driving the economy into a deflationary recession. In late 2000, the Fed asphyxiated the economy, which was growing at more than 4 percent, by shrinking the monetary base by 3 percent and sucking the oxygen out of the marketplace.

    Recession is here, and it is spreading around the world. GDP declined at a 0.4 percent annual rate from July through September, which almost surely will be revised downward at the end of November, when more complete data are available. Excluding the public sector from the calculation, private business output fell at an annual rate of 1 percent in the third quarter. The fourth quarter will be worse. Around the world, the Organization for Economic Cooperation and Development has slashed its 2002 economic growth forecast for its 30 member states from 2.8 percent to 1.2 percent, and countries like Argentina, with currencies linked to the dollar, are being crushed by the worldwide dollar deflation.

    Even now, however, most economists and government officials deny that deflationary monetary policy is the culprit. How, they ask, can we be experiencing deflation when prices continue to rise, when the Federal Reserve Board has cut short-term interest rates 10 times this year to their lowest level since 1961 and when the money supply continues to grow faster than the economy? Let me explain.

    First of all, prices are falling and have been falling for some time. In a deflation, price decreases begin with commodities that are traded on spot markets, like gold, industrial metals and agricultural goods, all of which have fallen substantially in price over the past several years. Both the Dow Jones Spot Index and the CRB commodity futures price index reached new low points in October. If the deflation persists, the price declines work their way up the production ladder to finished goods and eventually to real estate and wages, which we are beginning to see.

    While the sticker prices of automobiles continue to rise, the real price of cars has plummeted as dealers offer zero-percent financing and other manufacturers are offering deep discounts. Commercial rents are beginning to fall, and even notoriously flawed price indices, which substantially overstate price increases, have begun to reflect falling prices. In October, producer prices fell 1.6 percent, the largest decline ever. During the past three months the consumer spending deflator declined at a 2.4 percent rate. Although the overall GDP price index rose by 2.1 percent in the third quarter, every major component price index was down except for government prices, which were unchanged. The price index for gross domestic purchases fell 0.3 percent, the first decline in this price index since 1952. The increase in the overall price index resulted from a statistical fluke in the way the index is constructed. Import prices are subtracted in the GDP formula, so a large drop in import prices gave the appearance of boosting inflation by 2.6 percent - two negatives make a positive. Without that statistical perversity, prices actually fell 0.5 percent overall in the third quarter.

    The Fed has only one job: to defend the value of the money. We want the value of our money to remain constant rather than increase or decrease, and that is what we look to the Fed to do.

    Central bankers have no business attempting to fine-tune the economy to achieve the "proper" rate of economic growth. Only markets can make that determination. Markets don't spontaneously spin out of control and require central bankers to dampen "irrational exuberance." Conversely, monetary policy cannot be used to increase the long-run growth rate or lower the unemployment rate. Neither can it counteract fiscal and regulatory impediments or natural disasters or acts of war that cause the economy to slow down or contract.

    At the beginning of the year, when the Fed recognized it had put the economy on a hard-landing trajectory, it quickly reversed course and began lowering its interest-rate target 10 times this year for a total of 450 basis points. But as fast as the Fed increased the supply of liquidity, the demand for liquidity rose faster as people preferred to hold money whose value was rising rather than equities whose value was falling.

    The Fed thought it was easing because it was lowering short-term interest rates, but with the demand for money rising faster than the Fed could increase its supply by gradually lowering interest rates, the net effect was insufficient liquidity and a deflationary squeeze. Perversely, when the demand for money is increasing rapidly, the Fed ends up draining liquidity from the economy in order to keep short-term interest rates from falling below its target even as it lowers the target. So each incremental reduction in interest rates leaves the Fed behind the curve and the economy short of liquidity.

    Instead of worrying about interest rates, the Fed should be buying bonds, which will inject liquidity into the economy, until commodity prices and the price of gold rise off their lows and other prices stabilize. The market will determine interest rates when the Fed targets price stability.