- The Washington Times - Friday, May 9, 2003

Inflation causes prices to rise because the Federal Reserve creates more money than the economy needs. Conversely, deflation results in falling prices because the central bank creates a shortage of money.

So, if the most important goal of monetary policy is domestic price stability — i.e., neither the risk of inflation nor deflation — then the Federal Reserve should pump additional cash into the economy as an insurance policy to guard against the lingering threat of deflation.

At the FOMC meeting this week, the central bank acknowledged the ongoing risk of deflation by tilting its so-called policy bias in that direction.

But they failed to act. Immediately following the FOMC policy statement, futures markets priced in a one-quarter of a percent easing move for the June 25 meeting.

While some reflationary signs are appearing, most notably stronger gold and commodity prices and an easier dollar, it’s not yet entirely certain that deflation has completely passed us by. Business prices are now rising at about 1 percent. This is not much of a comfort zone since the way government measures prices — in particular, the prices of services — is imperfect at best.

Durable goods prices, however, have been falling steadily by nearly percent. This is exactly what Alan Greenspan and the Federal Reserve should be concerned about. Household equipment (appliances) is deflating at about a 5 percent rate. The “other durable goods” category is deflating by about 1 percent. Motor vehicles and parts are falling by slightly more than 1 percent, probably more if zero financing charges are figured in.

Other more widely followed price indexes, such as those for core personal spending, producer prices, and consumer prices, are barely more than 1 percent.

But again, that’s pretty close to the edge of deflation when measurement flaws are taken into account.

Treasury yields provide more evidence we’re not yet out of the deflationary woods. If deflation expectations have truly been eliminated and growth expectations have taken over, then the difference — or the “fed spread” — between the interest rate attached to the two-year Treasury note and the federal funds interest rate would be much wider today.

And if growth expectations and pricing power have recovered sufficiently, then Treasury rates across the maturity spectrum would be rising noticeably from higher inflation-adjusted real returns that would track stronger real investment returns in the economy. But that has not yet happened.

During the investment boom of the second half of the ‘90s, interest on the 10-year Treasury note averaged 6 percent, in step with growth of real gross domestic product. So, today’s unusually low 33/4 percent yield for the bellwether Treasury should revert to a higher rate characteristic of stronger economic performance.

In 1973, when I was a young pup just starting out as an open-market-operations economic analyst at the Federal Reserve Bank of New York, deflationary price readings would have been unthinkable. At the time, double-digit inflation expectations were embedded in every day American economic life, as symbolized by the collapse of the U.S. dollar, and the skyrocketing advance of gold, commodity, and related hard-asset prices.

Then, as Paul Volcker and his successor Alan Greenspan gradually and continuously restrained money creation by the Fed, inflation anticipations were finally reversed. But now the question is, have policymakers unwittingly launched a new era of deflationary concerns?

Supply-siders like myself believe it must pay adequately, after-tax, to work and invest more. Given what has happened to the stock market in recent years, it will have to pay much more, after-tax, to induce substantial new investment. That is why the president’s tax package makes sense. By significantly reducing taxes on dividends, income (including small-business income), and capital gains, the Bush plan will substantially lower the federal tax bite on capital — which will go a long way toward boosting real investment returns in the economy.

But investment returns also depend on business pricing power and profits.

While it would be futile to pursue a monetary policy that simplistically seeks to inflate business prices, it is nonetheless important to avoid profit-wrecking deflation.

During the early part of 2002, the Federal Reserve loosened up quite a bit in an attempt to aid an economy that was still reeling from the events of September 11, 2001. By temporarily decontrolling its policy of targeting the overnight interest rate, it opened the door to massive money-adding operations that contributed to 4 percent GDP growth and an S&P; 500 that hit 1,150. That’s just what we need to happen now.

In order to blunt business worries over the threat of long-run pending price declines, to open wide the door to steadier prices, production, profits and investment returns, and to finance lower tax rates on capital, the Fed should take out an insurance policy by stepping up its money-adding operations. Today. Do it between meetings. Let the market determine interest rates. Just keep pumping in new cash until prices and market rates signal that deflation is over.

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