Greasing the Wheels of Commerce Jude Wanniski December 3, 2004

It does feel nice this holiday season to have Wall Street in its nicest rally of the year, so enjoy it while you can. In the early 1970s, when we were in the early stages of the inflation that began when President Nixon took the dollar off gold, it was said by a great many opinion leaders that “A little bit of inflation greases the wheels of commerce.” The more sober of those who watched the CPI and PPI edge upward month after month recalled the “punch bowl” comments by former Fed Chairman William McChesney Martin, who noted while it might be nice to have a little inflation, there would come a time when it would be necessary to take away the punch bowl and put an end to the party.

It was easier said than done. By 1979, the price of gold had climbed to $240 from its starting point of $35 oz, and the increases in the CPI and PPI were beginning to get serious as old contracts unwound. Workers in particular pressed for higher wages and automatic cost-of-living adjustments. It was surely time to pull away the punch bowl, but in 1979 President Carter was getting ready to run for re-election in 1980 and his team decided to do an end-run on the punch bowl. Having installed Paul Volcker as the new Fed chairman in the spring of 1979, the Carter economic team decided that 1980 was going to be a much better year for economic growth than had earlier been thought. This meant the economy would need a bigger stock of money! In October 1979, Volcker himself announced that the Fed would have to put aside the earlier interest-rate targets and directly address the economy’s greater need for “M,” i.e., the money supply.

The monetarists were jubilant. At last they had gotten their way, and with a Democrat in the White House and Democrats in control of both houses of Congress. In trying to get the “M’s” to rise in accordance with monetarist rules, the Fed began shoveling reserves into the banking system as fast as they could. But when the M’s were announced in the weeks that followed, they did not seem to have budged at all, so they shoveled some more. The price of gold, on the other hand, went through the roof. By January 21st it was trading at $850 oz and interest rates were soaring. It was several months before the numbers were collected on M “velocity,” which the monetarists had assumed would remain constant. It had not, and prices were off to the races. Gold stayed above $600 for most of the year and did not come down until expectations of the Reagan tax cuts increased the demand for liquidity, which made the dollar scarce relative to gold.

This history is most relevant now, with Wall Street already a bit tipsy at the Fed’s punch bowl. In this case, though, the Fed actually believes it has been withdrawing the punch bowl at a measured pace by raising the federal funds rate and promising to raise it again and again until it is sure inflation has been contained. In my memory it is the first time the Fed has been targeting the federal-funds rate as its sole objective. Always before, it targeted funds in order to reach a primary economic objective. In 2004 for the first time, Chairman Greenspan has indicated the Fed would essentially experiment with the funds rate, raising it gradually until it reaches a point, which would self-evidently balance inflation and employment. The policy is not quite in tatters, with gold climbing and the dollar collapsing against the euro and yen, but the global business world is now getting increasingly nervous about what all this means for the terms of trade with the U.S. The decline in the price of oil adds to the confusion, helping lift equity prices and at the same time suggesting inflation really must be under control, but OPEC will soon cut production if it is being paid in ever-cheaper dollars.

Fed Governor Ben Bernanke, who has worked with Greenspan over the last year to develop this new experimental approach to monetary policy, yesterday addressed the Economic Club of Washington, D.C., more or less reiterating a speech Greenspan gave last January, but with his own distinction. Bernanke begins, though, by rejecting the idea of “mechanistic” rule, by which he means the kind of automaticity required if there were to be a fixed commodity target: “First, the term ‘rule’ suggests a rigid and mechanistic policy prescription that leaves no room for discretion or judgment. However, the argument that monetary policy should adhere mechanically to a strict rule, made by some economists in the past, has fallen out of favor in recent years. Today most monetary economists use the term ‘rule’ more loosely to describe a general policy strategy, one that may include substantial scope for policymaker discretion and judgment.”

The two policy approaches he discusses are “the feedback” approach and the “forecasting” approach. The “feedback” rule is simply trial-and-error, moving the funds rate around to see what happens from one FOMC meeting to the next. The second, which he favors, means you put on your forecasting hat, making your best guess on where the economy is going to be, say, six months from now, and moving the funds rate to accord with that guess. As pointed out above, this is what led Volcker in October 1979 to shovel reserves into the banking system, a forecast of rapid growth and money demand.

As our West Coast colleague Wayne Jett observed, after reading the Greenspan speech and the Bernanke speech: “The elephant in the living room that neither AG nor BB acknowledges is that every crisis encountered by the Fed was precipitated by the Fed`s lack of any strict rule of monetary policy requiring and providing a stable value for the dollar. With such a rule, any financial problem has entirely private origins and is resolvable accordingly. Without such a rule, crises resolvable only through extraordinary measures by the Fed will inevitably continue to arise.”

The only good news in this picture is that we are still in the early stages of this new inflation, about where the economy was in November 1971 -- when it was still possible to get the inflation genie back in the bottle. Knowing what to expect if things get worse, the Europeans and Japanese are now talking of joint action to support the dollar. It should eventually occur to them that it is the Fed’s job to support the dollar, which can be easily done as I pointed out earlier this week in "What Should Greenspan Do?” Toss out the “feedback” and “forecasting” models and target $400 gold, exactly the prescription Steve Forbes proposed in his column the following day. It would work like a charm and there would be no painful after-effects, no hangover.