The Fed, the Monetarists and the Phillips Curve Jude Wanniski & David Gitlitz June 3, 1994

Over the last few weeks, we have been exploring the Fed's interest-rate targeting procedure due to the dearth of evidence that the "tightening" process underway for the past four months has actually tightened -- in other words, restricted -- the availability of liquidity to the financial system. In fact, all signs continue pointing to an abundance of high-powered money creation, confirmed by, among other things, rapid growth of Federal Reserve Credit and the St. Louis Fed monetary base. These statistical representations mirror operations of the Fed's open market desk, which has been nothing if not generous toward the liquidity needs of the banking system.

Some of our friends with monetarist leanings (yes, we do have some) suggest we have been misreading these signals. They point primarily to the fact that actual bank reserves have been flat to declining during most of this period, M1 growth soft, and say the rise in base money is almost entirely the result of increased currency in circulation. Currency, according to this view, is far less of a concern because it is at least as likely to turn up in the pockets of Russian gangsters as of U.S. consumers. On the basis of these factors, this analysis concludes that the Fed is indeed tight.

The burden of proof, however, is somewhat more rigorous. If the Fed were quelling inflation expectations and keeping money scarce, the gold price would have dropped, the dollar strengthened, and long bond yields would have at least settled down after the Fed's most recent move on May 17. That action was widely advertised as having "substantially removed" accommodation from policy. Instead, the gold price is stuck between $380 and $385, right where it was in early February, the dollar is down about four yen from its already weak levels at that time, and the long bond is riding a roller coaster of volatility. 

If flat-to-negative growth in reserve aggregates is synonymous with Fed tightness, what is one to make of this passage from the New York Fed's report on its open market operations during 1992: "Total system holdings of U.S. government securities [i.e., Fed credit] rose by $30.2 billion in 1992....The expansion of the system's portfolio over the year was largely prompted by declines in reserves arising from movements in various operating factors. On balance, these factors drained almost $30 billion of reserves between the maintenance periods ended January 8, 1992, and January 6, 1993. Currency growth of $27 billion accounted for most of this reserve drain." [Emphasis added] The monetary "operating factors" described here are very similar to current conditions, with one important exception: the Fed was easing throughout 1992, with the funds rate target dropping from 4% to 3% during the course of the year. 

The fact is, since February the desk has merely been accommodating whatever demand for credit emerges at the higher rates, which it is forced to do under the fed funds targeting regime. In the current environment, this operating mechanism appears to be confirming rather than quelling inflation expectations, resulting in higher loan demand throughout the financial system, including in the fed funds market. Commercial and industrial loans, for example, are rising at an annual rate of 11%. Higher lending activity, of course, is not in itself inflationary, and might under normal circumstances simply reflect an expanding economy. This activity, however, is occurring at the same time other inflation alarms are sounding, and it looks to us like the building blocks of a classic "too much money chasing too few goods" inflation outbreak. 

This problem with the fed funds targeting regime also reveals the destructiveness of the notion that inflation pressures can and should be subdued by slowing growth. Media reports continue to quote the concerns of unnamed "Federal Reserve officials" that unemployment below a certain level -- like maybe today's report of 6% for May -- is inflationary. The idea, first generated by a British economist named Phillips, is a continuing artifact of the so-called "British disease," which came to be known as stagflation.

Stagflation first became evident after WWII, when Britain left its income tax rates at wartime levels, 95% at the top, and tried to stimulate its economy through monetary ease. Because the UK was part of the Bretton Woods gold standard, tying sterling to the dollar and the dollar to gold, excess money in the banking system would cause an incipient weakness in sterling. The Bank of England was forced to offset this by buying sterling with borrowed dollars. The IMF would eventually "permit" the UK to devalue, relieving all sterling debtors. Temporarily, employment would rise as the market increased demand for goods to beat rising prices. The Phillips Curve tracked the temporary increase in employment with the rising inflation rate, and posited a trade-off. The resulting inflation, however, would cause bracket creep in the income tax rate thresholds, not only slowing the economy, but also causing the labor unions to get ugly, discovering they had agreed to contracts in devalued sterling. 

The United States imported inflation partly on the argument that the Phillips Curve had demonstrated in England that inflation would produce more jobs. Because the U.S. was at the center of Bretton Woods, it had to destroy Bretton Woods in order to devalue. The U.S. Keynesians at the time, led by James Tobin of Yale, Robert Solow of MIT, and C. Fred Bergsten, Henry Kissinger's economist at President Nixon's National Security Council, argued for dollar devaluation as a means of increasing employment. They did not cite the Phillips Curve at the time, but instead gave it a twist, arguing that a cheaper dollar would enable the Japanese to buy more U.S. goods, increasing employment. The more expensive yen would cause Americans to buy fewer Japanese goods, thereby causing them to buy more U.S. goods, which would also increase U.S. employment. Underpinning this theory was the ridiculous mercantilist idea that if we trade three loaves of bread for three bottles of Japanese sake, devaluation will change the terms of trade, and we will now send Japan four loaves of bread in exchange for two bottles of sake. Employment will increase because Americans must now make an extra loaf of bread!!! 

The Nixon Treasury Department in 1971 actually calculated that the initial devaluation of 13% would increase U.S. employment by more than 500,000 jobs. When the wage and price controls were lifted, and inflation became apparent, the Keynesians -- including the GOP Keynesians such as Herb Stein -- dragged out the Phillips Curve to show that inflation wasn't so bad, since at least it increased employment. Unhappily, the standard of living in the U.S. has dropped ever since, excepting the advance during the Reagan years. Per capita employment is, of course, much higher as husbands and wives now have to work full time, and moonlight as well, just to attempt to maintain their real income in the face of the steady slide in living standards wrought by the Keynesians. 

The Phillips Curve translation widely accepted by politicians, journalists and unnamed "Federal Reserve officials" is that economic growth is inflationary. But if the currency was maintained on a gold standard, economic growth would not be inflationary because a generalized rise in the price level would not occur. When you are in a floating regime and devalue the currency, GNP appears to rise before the inflation shows up statistically, as private transactors add to inventory to beat rising prices. This is why Greenspan's statements so often seem contradictory -- when he says economic growth need not be inflationary, and there is no Phillips Curve trade-off, but that if the economy grows faster because of excess credit, there will be inflation. 

Greenspan's problem is that the optimum price of gold is $350 and he has allowed the dollar to devalue to $385. The inflation process is underway, and the glitch in the Fed's operating mechanism is preventing the price of gold from falling back to $350, which is the only way to bring a resumption in the bull market in bonds. Accepting 10% inflation, which Greenspan knows he would have to do if he allows gold to remain at $385, does not only keep the bond market unhappy. It also causes a steady erosion in stocks, as the creeping inflation impacts the tax system, especially non-indexed capital gains. If by some magic Greenspan could announce a firm commitment to gold at $350, the price of gold would fall and the bond and stock markets would boom, seeing a non-inflationary expansion ahead. Commodity prices would rise somewhat, though, to call forth the production required to feed the expansion, not simply to beat a monetary inflation.