Play by the Price Rule
It will help get us back into the virtuous cycle.

Mr. Canto is Chairman of La Jolla Economics
October 12, 2001, 8:00 a.m.

uring the months leading to the terrorist attacks of September 11, there was considerable discussion as to whether the U.S. economy was headed for a recession. The events of September 11 added considerable turmoil to the economic outlook. To the administration’s credit, they have adopted a rapid response to the situation. On the economic front, all parties involved seem to have a desire to minimize the economic damage of the terrorist attack while at the same time aiming to get the economy going again.

Among the issues the policymakers must deal with is how to separate the temporary impact of the disaster from the permanent, and how to harmonize the overall economic policy package to get the economy and the markets going again. In so doing, they must remember that the economic outlook prior to September 11 was not that rosy. In short, there was an existing condition that must be incorporated into the analysis. To get the economy going again we must find the causes for the initial slowdown to ensure that we don’t make the same mistakes again.

Looking back, one of those mistakes seems very clear. The Fed departed from the price rule, which in turn led to an economic policy resembling the action of a yo-yo. This increased uncertainty in the markets and arguably contributed greatly to the slowdown.

The case against Greenspan is a compelling one. First, let’s argue the price rule. Without explicit evidence that the Fed ever adhered to a strict price rule, one can make inferences as to whether the Fed has used a price rule. Recall that Greenspan took over the helm at the Fed in 1987. During the market meltdown he was wonderful. He made sure that the system had enough liquidity to function. In fact, that has become one of his trademarks — during times of crisis he has flooded the market with liquidity. For that he deserves high marks.

During the 1990s, as the Greenspan Fed came of age, the chairman seemed to find the magic wand that kept the inflation rate on a downward trend towards the 2% to 3% range. Recall, there was a big debate as to whether a 1% to 2% rate was statistically the equivalent of 0% inflation because of the impact of productivity and the way prices were measured (i.e., list vs. transaction). At that time Greenspan began talking about productivity, and one can argue that he relaxed the speed bumps to the 4%-plus range and followed the price rule.

Then came 1997 when he began to worry about irrational exuberance, the market impact on net wealth, and the pace of economic activity. He began to include the stock market on his list of policy targets, and reintroduced targeting of the monetary aggregates in his February 26 Humphrey-Hawkins testimony.

The attempts to slow the money supply relative to strong money demand (as measured by real GDP growth) resulted in a decline in the inflation rate. For the first time in a decade, the inflation rate fell below the 2% target range. Some East Coast supply-siders, rightfully so, began complaining about deflation. The Fed had deviated from the price rule and had undershot its price stability target zone. The market continued to rise and by the end of 1998 the Fed began worrying about the century date change. It was not until 1999 that the Fed began adding significant amounts of liquidity to the system in anticipation of Y2K. In his Humphrey-Hawkins testimony of July 1999, Greenspan stated that the Fed had taken ample precautions to ensure that sufficient currency was available.

Not surprisingly, inflation began to creep higher. Y2K, largely because of Greenspan’s leadership and preparations, became a non-event and the Fed began the process of withdrawing the liquidity it had provided. But late in the decade, it also appears that Greenspan abandoned the automatic adjustment of the price rule in favor of a more activist and ad-hoc system. The result is that the inflation rate has been more volatile. The attempts to micromanage the economy have increased the variability of the inflation rate, and that is not good for the economy.

Increases in the Fed funds rate have preceded economic slowdowns, while declines in the rate have preceded acceleration in real GDP growth. Thus, if the Fed truly controls monetary policy and the Fed funds rate, it follows that the Fed is partially responsible for the slowdowns as well as the economic expansion of the past decade. Our interpretation suggests that the best times were when the Fed adhered to the price rule. The Maestro should return to his price rule magic wand and get rid of his activist, fine-tuning wand. If Greenspan did lose his compass, it is time to regain it or else he should leave.