- The Washington Times - Saturday, November 27, 2004

It has been eight months since the Federal Reserve Board surprised the financial markets by announcing it might soon end its accommodative monetary policy to head off an inflation it suspected lurked in the wings.

Then, Fed Chairman Alan Greenspan told Congress it might only take a quarter-point rise in the interest rate charged to banks for overnight reserves (the “federal funds rate”) to strike a balance between inflation and economic growth.

The rate was then 1 percent, the lowest since 1958. And after four quarter-point increases beginning June 30, it is now 2 percent. Yet serious market commentators say the rate may have to go to 3 or 4 or even 5 percent to halt the slide in the dollar against other currencies and gold.

Not only have we argued all along that the Fed’s premise of a higher funds rate strengthening the dollar is invalid, but also that the increases would more likely turn a small inflationary problem that could cure itself if left alone into a larger problem that would cause economic distress.

Indeed, the dollar is now at its weakest levels of the year against the euro and the Japanese yen. And an ounce of gold, which cost $380 in the midst of the Fed’s inflation concerns last spring, traded last week at $440. Instead of reviewing the policy that was supposed to work in the opposite direction — a policy with no known support in modern economic theory, its advocates say the Fed has been too timid. The Fed though, has been flying blind, on a hunch that the higher rates would reduce inflation expectations.

No direct correlation exists between the funds rate and inflation, however. Inflation is an entirely monetary phenomenon caused by many variables affected by Fed practices and the market. If the Fed had a mathematical formula defining how the dollar’s unit value is determined, the funds rate might be one variable in the formula. At best, fixing or adjusting the funds rate leaves all other variables, including the dollar’s value, free to change. In fact, doing so makes change in the dollar’s value almost inevitable.

The nature of this change is unpredictable, though, because so many variables other than the funds rate are present. Thus, the funds rate is not really a “tool” for managing the dollar’s value. It is no more than one variable among many. Targeting the funds rate as the Fed does actually hurts more than it helps dollar stability. The monetarist experiment of 1979-82 had the same problem when it targeted the money supply and assumed the demand for money (its velocity) would remain constant. When it didn’t, the gold price went through the roof and so did the inflation rate and bond yields.

The only way the Fed can achieve dollar stability is by directly targeting a specific value. In theory, the Fed could target the value of the euro and avoid inflations and deflations as long as the European Central Bank targets commodity prices as it adds or subtracts money to meet the market’s demand for liquidity. At one point during the disastrous monetarist experiment at the Fed, the Carter administration even gave thought to targeting the Japanese yen.

The most reliable target would be gold, which was the key to the Bretton Woods system President Nixon abandoned in 1971 in an attempt to inflate the economy into prosperity. Alan Greenspan still discusses this operating mechanism with nostalgia in congressional testimony, but says it is up to Congress to make the change.

At an exchange rate closer to $400 per ounce, the Fed would simply add or subtract money supply to keep the price constant. The market would almost instantly adjust all other variables, including interest rates.

In 1987, former Treasury Secretary James Baker III proposed an international monetary reform to stabilize exchange rates, with a “basket of commodities including gold” as a reference point. But adding more variables to a gold target merely increases instability because, as Mr. Greenspan has noted, the world’s large stock of gold relative to demand makes it the least vulnerable to temporary supply-and-demand considerations.

Raising the funds rate does nothing to curb inflation and may actively contribute to inflation expectations through the rise in the price of gold, the most monetary of all commodities.

The financial markets, after all, are told the higher rates are needed to slow the economy and reduce demand for goods and services that drive up prices. But a slower economy will reduce the need for dollar liquidity, and the Fed’s current operating mechanism has no way to drain surplus money from the exchange economy. So prices of goods are bid up, not down.

Since raising the funds rate to fight inflation has no realistic chance of success without recession, the prospect of a virtuous cycle as described above should be tried. Were the Fed to abandon its inapt use of the funds rate target, of course, this exercise would be unnecessary. Sound money would relieve the economy of such distractions.

Jude Wanniski is president of Polyconomics Inc. Wayne Jett is the New Jersey firm’s West Coast representative in Pasadena, Calif.

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