24 Aug 2008

Is the Fed Inflating or Deflating?

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At first you would think this should be an easy question for economists to answer–much like asking a doctor, “Is the patient’s fever getting worse?” However, there is actually healthy disagreement on the point even within the narrow group of very-free-market economists. Hard money guys like Peter Schiff have been warning that the US dollar is dead as a doornail, while Gary North (pdf) has actually been warning of deflation for over a year. (Note on nomenclature: For North, “deflation” means a falling money supply, which should tend to lead to lower prices. But the price movements are not the definition of inflation/deflation for him.)

Part of the problem is that some things are zigging instead of zagging, and we economists don’t like change. As I explain in this piece, normally when the Fed cuts its target rate, this goes hand in hand with an increase in the money supply (however you want to define it). But since the credit crunch, the Fed has slashed interest rates even while the rate of growth in aggregates such as the base and M1 is very tame, by historical standards. Hence, some economists are aghast at the “easy money” Fed policy, while others are screaming that Bernanke is insane for putting on the brakes while the credit markets are frozen.

Below is a chart (reproduced from my article linked above) showing that the textbook relationship hasn’t held during the credit crunch. Note that by Feb 2008, total bank reserves had fallen more than $1 billion since the previous summer, even though the Fed had cut the target rate 225 bp by that time. That’s not how things used to work on the blackboard when I taught at Hillsdale College, I can tell you that!

As always, the explanation for all this is that in economics, its laws are only true when you hold “everything else equal.” In September 2007 and beyond, certain key interest rates (apparently) were falling on their own because of the new conditions. In that context, it’s hard to say whether the Fed was “contracting” or “expanding.” Part of the problem is that the very presence of the Fed distorts market behavior; it is impossible for the Fed to truly “follow the market” and “not intervene,” as some economists recommend. That’s like telling the Soviet planners to mimic what the market would have done.

We will return to these issues often in future posts. The lesson is that we need to be careful before applying rules of thumb that are inapplicable because conditions are different from previous downturns.

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