Inflation Is a Clear and Present Danger By BRIAN WESBURY
August 19, 2008
The most painful and frustrating economic policy blunder
of the past 50 years was the Great Inflation of the 1970s.
Painful, because it was the catalyst for three damaging recessions
(1973-75, 1980, 1981-82), all the while eroding living standards
and seriously undermining confidence in America.
It was also deeply frustrating. Despite the teaching of Milton
Friedman -- which clearly explained that inflation was caused
by too much money chasing too few goods -- a combination of
bad economic models, denial and political expediency allowed
it to happen.
would think that the odds of a repeat were low, and for 20
years, after Ronald Reagan and his Fed Chairman Paul Volcker
had the courage to get inflation under control with tight
money and tax cuts, this was true. Unfortunately, the lessons
seem to be fading. Today, the U.S. (and through it the world)
faces its greatest threat from inflation in 30 years. And
as in the past, this threat is being met with denial and political
Today's problems began seven years ago in 2001, when the
Federal Reserve overreacted to the deflationary mistake it
made in the late 1990s. The Fed vigorously pumped money into
the economy in order to drive interest rates down rapidly.
As is so often the case, after the Fed has acted, but before
the typical lag in monetary policy has fully played out, conventional
wisdom argues that the Fed has become impotent. Back in 2002
and 2003, the logic was that the Fed was powerless over globalization,
and low-cost labor would continue to feed deflation. In addition,
because long-term rates were rising as the Fed cut short-term
rates, many thought that markets were undermining Fed intentions.
But, as always, when the Fed injects excess liquidity into
the system, inflation begins to rise. As early as 2002, soaring
commodity prices and a falling dollar became the canaries
in the coal mine of excessively loose monetary policy.
In their wake, almost every measure of inflation in the U.S.
has moved significantly higher. In the past year, producer
prices have increased 9.2%, while consumer prices are up 5.6%.
Yet, because there are so many measures of inflation it is
possible to focus on some, for instance consumer prices excluding
food and energy (aka, "core" CPI), which remain
benign. This allows many to say there is no inflation.
But oil and food are absorbing a large part of excess Fed
liquidity. When consumers spend more on energy, they have
less to spend in other arenas. This reduces demand for other
goods, keeping prices lower than they would be otherwise.
This helps explain the divergence between overall and core
measures of inflation.
This divergence is now coming to an end. If the recent decline
in energy and food prices continues, that money will be released
and other prices will start to rise more quickly. The July
jump of 0.3% in "core" CPI inflation is likely one
of the first signs.
Some argue that the recent drop in commodity prices indicates
lessening inflationary pressures. But nothing could be further
from the truth. Commodity prices had reached levels that were
not justified by current monetary policy. As a result, their
pullback is just a correction, not the beginning of a new
trend. If this pullback had occurred as the Fed was lifting
the federal-funds rate, like back in 1999, it would be a different
story. Excluding food and energy from the CPI is sometimes
justified because their price movements are often volatile
and short-lived. But the five-year average annual growth rate
of the CPI, which should smooth out any short run issues,
is now 3.6% -- its highest level since 1994. Moreover, the
Cleveland Fed's trimmed mean CPI, which excludes the 8% of
prices growing the fastest and the 8% growing the slowest,
is also up 3.6% in the past year -- its fastest growth since
When investors hear comparisons of today with the 1970s,
they immediately think double-digit inflation. But, it's not
that bad -- yet. It took 20 years of accommodative monetary
policy in the 1960s and '70s to create the Great Inflation.
A more accurate comparison on the inflation front would be
the late 1960s, when consumer price inflation accelerated
to 6% from about 1%. This period was the precursor of the
1970s. Except for catch-up after the wage and price controls
of 1971, the actual move into double-digit inflation did not
occur until the late '70s.
With the real (or inflation-adjusted) federal-funds rate
now negative, the signals are clear. The Fed is still adding
more money to the system than is demanded, and this suggests
that the general increase in inflationary pressures will continue.
The only question is whether policy makers will get the courage
to fight inflation before it gets out of control.
And this is the rub. Much like the 1970s, there is a widespread
denial that inflation is a problem today. Some argue that
Fed policy is not easy, either because the money supply is
not growing, or that banks are deleveraging, which counteracts
any attempt by the Fed to inject money.
The first argument hits at the root of Friedman's monetary
theory. If money is not growing, then how can inflation be
a problem? But money is growing. No measure of money is declining,
despite bank deleveraging, and Reserve Bank Credit (the Fed's
balance sheet) has expanded at a 14.4% annual rate in the
past three months.
Another sign of easy money is that every country that pegs
to the dollar, including China and the United Arab Emirates,
is experiencing a rapid acceleration in its inflation rates
as it imports inflationary U.S. monetary policy.
The second argument is belied by history. Between 1983 and
1994, exactly 2,747 U.S. banks and S&L's failed, representing
total assets of $894 billion. During that period of deleveraging,
real GDP in the U.S. expanded at an annual average of 3.5%.
The Great Depression is the only period of sharp economic
contraction in the U.S. correlated with bank failures. But
that was clearly related to a deflationary mistake in Fed
policy. Real interest rates were outrageously high in the
late 1920s, and much of the '30s, which is not true today.
One of the reasons that monetary policy is so loose today
is that our economy is addicted once again to easy money and
low interest rates. We hear over and over that the Fed cannot
tighten because the housing market and the economy are vulnerable.
This was the same argument made in the pre-Volcker 1970s,
when the U.S. bounced from one economic crisis to the next.
But a look back at the past 40 years clearly shows that the
economy was much healthier in the 1980s and '90s, when real
interest rates were high, rather than low as they were in
the 1960s and '70s.
The Fed's "dual mandate" -- to keep the economy
strong and prices stable -- serves to support this mistake.
In contrast, the European Central Bank has a single mandate:
price stability. No wonder the dollar has been so weak relative
to the euro. Imagine two football teams. One with a single
mandate: win. The other with a dual mandate: win and keep
your uniforms clean. It's clear that the one with the single
mandate will have more success in achieving its goals over
It is this combination of denial of actual inflation, bad
economic models and the political expediency of keeping interest
rates low that makes a repeat of past policy mistakes likely.
In the end, inflation can be controlled -- the Volcker-Reagan
strategy of tight monetary policy and tax cuts still holds
the key -- but only if policy makers find the courage.