Watch Out For That Primrose Path

April 21, 2008

The FOMC is authorized to use monetary policy to promote growth and preserve price stability. As every serious student of economics learns, that dual mandate creates an immediate problem. Satisfying two objectives with one policy tool is like trying to solve an algebra problem that has two unknowns but only one equation. For a sound reason, most central banks are entrusted with the single task of guarding the internal value of the currency, that is securing low, stable, and predictable inflation. Doing that year in and year out tends to maximize growth under conditions where no other factors are changed.

Chairman Bernanke earned the somewhat derogatory nickname, Helicopter Ben, in his earlier stint as a Fed Governor. When a U.S. deflation was feared in 2003, he famously suggesting dropping money from the sky as a counter-meausre. Inflation is a monetary problem when all is said and done, and Bernanke’s suggestion was hardly original. Academic economists are fond of conducting thought experiments. Dropping money from a helicopter as a response to price deflation was already established in the literature when Bernanke raised the idea.

Now is not the time for the helicopter stunt, however. The U.S. and world economies suffer from excessive and accelerating inflation and are not at risk of falling prices. The U.S. has not yet reported a single quarter of negative growth. The money stock is expanding briskly. The dollar hovers near a record low against its chief reserve currency rival, the euro. Oil keeps hitting new highs. Gold prices have soared during the past year. But the Federal funds rate of 2.25% is 175 basis points below the 4.0% 12-month rate of consumer price inflation. We economists call that a significantly negative real (i.e., inflation-adjusted) benchmark interest rate. Negative interest rates were the signiture mark of Fed policy under Arthur Burns in the 1970’s, and they got the U.S. economy into a heap of trouble. That’s one primrose path policymakers should think hard about before following.



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