December 19, 2005,
Unlike a lot of economists, I’ve never truly believed that the Federal Reserve is really my friend, or a friend of financial markets and the economy. True enough, I started at the New York Fed over thirty years ago, and got a good education there. But frankly, I’d rather bet on America’s free economy, and the men and women who do the real heavy economic lifting by exercising their God-given talents to invent, produce, take risks, and work hard at their jobs, than bank on the Fed. This is provided of course that the U.S. government gets out of the way by allowing for sufficient after-tax rewards and incentives. Deregulate America, and U.S. capitalism will soar. Whether it’s monetary or fiscal, central planning is the antithesis to prosperity.
All of that said, a quick thought passed through my mind following the Fed policy meeting last week. I had just closed my eyes and leaned back while listening to some calm music, and I almost came to believe that the high priests of money might be basing their policy on forward-looking bond indicators, which is exactly what they should be doing. The question is: Will friendly thoughts like this last for very long?
I still can’t forgive the central bank for decimating and deflating the bullish stock market economy five years ago, a move that temporarily ended the great productivity surge of the Internet revolution. But perhaps they have learned a thing or two, and perhaps the arrival of the brilliant Ben Bernanke as Fed chair will be an occasion for real change.
In shorthand, the Fed’s policy statement last week strongly suggested that the recent 18-month tightening cycle will soon come to an end. They raised their target rate from 4 percent to 4.25 percent, and perhaps there’s another small move or two left. But bond-market indicators have for quite some time been signaling an absence of inflationary pressures a matter confirmed by the actual data where the basic inflation rate continues under 2 percent. Not only has the 10-year Treasury bond been hovering at a half-century low of 4.5 percent for many years, but the difference between this cash bond and its inflation-indexed cousin suggests that low inflation is here to stay for another decade.
More, broad-based inflation reminds me of Jimmy Carter. And despite the best efforts of the mainstream media, George W. Bush is no Jimmy Carter. Nor are these the inflationary Carter ’70s. Lower tax rates and skyrocketing productivity are counter to inflation.
Now, some of my supply-side friends take issue with my optimistic view on inflation. They believe the recent run-up in gold prices to over $500 an ounce signals excess money creation and much more inflation ahead. Therefore, some argue, the central bank must keep tightening and raising its target rate for at least another year.
But I believe this is a 1970s view one that abstracts from the Internet Google revolution and the record productivity surge, and also ignores the global spread of capitalism, which has taken hold in the post-Reagan years and has increased the demand for scarce commodities across the board.
Consider this: Daily average volume in the Treasury bond market runs up to nearly $90 billion, according to the Chicago Board of Trade. Gold trading, however, is well below $50 million, even in the recent rally. In other words the vast breadth, depth, and resiliency of the bond market suggest that this forward-looking indicator has the most clout in the world market place. This does not mean that gold is irrelevant as a monetary signal; but it does suggest that the Fed is on the right track with what appears to be a newly created bond-price-rule approach to policy. In other words, the central bank seems to be using the bond market as its leading real-world indicator.
In my view, this is as it should be. And if the authorities are still worried about a touch of future inflation, all they need do is sell bonds from their huge portfolio in order to drain liquidity and bypass the unnecessary fed funds rate target altogether.
As for gold, it may still be taking the temperature of global war and political uncertainty, and today it could be telling us more about the threat of nuclear weapons in Iran than the future course of American inflation.
For years, conservative economists have argued for a well-defined price rule. As the Fed moves into the Bernanke era, it looks like we’re getting one. Between forward-looking bond markets and backward-looking basic inflation rates, the central bank should be able to find the right policy that will not interfere with the day-to-day inspirations of the American entrepreneurs who have made our form of prosperous capitalism the envy of the world.