Saturday, April 08, 2006

When you're Fighting Inflation, Deflation Makes Your Work Easier

Ben Bernanke, chairman of the U.S. Federal Reserve Board, has an important enough job. Stable prices. To do it, however, he has only - his own words - "a single macroeconomic instrument." The symbolic federal funds rate. The overnight rate. All other rates, for days through decades, are set without fuss at public auction. Uniquely among the central banks, why does Mr. Bernanke's job look so difficult? What are we dealing with here? An impossible task? Or another big stage production of the Wizard of Oz? If so, where's the intrepid Toto when we need him to get behind the curtain and start yapping?

By way of exculpatory script, here's an excerpt from Mr. Bernanke's first congressional testimony: "no economic or financial indicator can provide reliable guidance." Here's another: "monetary policy requires painstaking examination." And another: "a simplification of the real world." And another: "sufficient data is not available." And yet another: "myriad global influences." And these all appear in a single paragraph. As chairman of the Fed, Mr. Bernanke may or may not be more "transparent" - comprehensible - than Alan Greenspan, his obfuscatory predecessor. He is already more revealing. He hints of mortal mind behind the curtain.

The Federal Reserve does work harder than other central banks. Its work ethic speaks for itself. First it prints excess money and induces inflation. Then it relentlessly raises rates to fight inflation. Finally it instigates recession. Normally, it keeps doing whatever it's doing until it goes too far. Then it repeats itself in reverse. Mr. Greenspan persevered through 14 consecutive increases in the federal funds rate (since June, 2004), lifting it from one per cent to 4.5 per cent. By contrast, aside from a single quarter-point increase in December, Europe's central bank hasn't touched its short-term rate for five years. Bank of Canada Governor David Dodge lifted only five times and stopped at 3.5 per cent, three-quarters of a point below the Fed rate. The Fed has done the heavy lifting.

With scant evidence of inflation anywhere, when will the Fed stop fighting it? It's evident that we're living in a low-inflation - perhaps no-inflation - world. Regardless of energy-price alarms and commodity-price alarms, core inflation rates haven't moved significantly in years, either in the United States or in the world. Scan the core rates for the last two years. For the last four years. For the last eight years. A few up-wiggles and a few down-wiggles aside, the chart shows a relaxed inflation rate that averages out at roughly 1.8 per cent. Factor in the inherent exaggeration that economists sense in all inflation indices and we probably have actual inflation at one per cent or less. As former Fed governor Edward Gramlich observed two years ago, inflation had been running "very close to zero" for seven years. It hasn't moved significantly since.

From the Fed's perspective, you can say that central bankers have done a superb job. Indeed, the Fed itself has already said so. As former Fed vice-chairman Roger Ferguson asserted in November, central banks have succeeded magnificently in controlling inflation. (The only Fed governor not appointed by President Bush, Mr. Ferguson resigned last week.) Here's his self-congratulatory appraisal: "Consumer price inflation in the advanced economies, over the decade beginning in 1997 and ending next year, looks set to come in at an average annual rate of less than 2 per cent, down from 3.5 per cent in the previous 10 years. As someone who started work as a monetary policymaker in 1997, I am happy to acknowledge the accomplishment of policymakers at the Federal Reserve and in other central banks around the world. Thanks to their success in fighting inflation, the central banking profession enjoys a very high standing." Well done, Roger. And thanks. You guys are great.

On the other hand, there's deflation. When you're fighting inflation, there's nothing like deflation to make your work easier. We're not quite into deflation yet - but we're probably not quite out of it, either. Core inflation rates around the world suggest that each insurgent inflationary force (think oil) has been approximately balanced by an equivalent counter-insurgent deflationary force (think GM, Ford and Chinese exports). As befits a globalized world, the deflationary force is international. Japan is emerging, tentatively, from a decade of deflation. China's inflation rate fell last year by half, from 3.6 per cent to 1.8 per cent - almost identical to U.S. and European rates. Canada's most recent rate is 1.6 per cent, a perfect bull's-eye in the Bank of Canada's inflation target.

Never in human history have so many machines been producing so many goods for so many people - making a modest excess of goods almost inevitable. The best solution is lower prices. The worst solution is a Fed-induced recession. With luck, Mr. Bernanke will stop lifting, will pause and rest a while. There should, nevertheless, be a better method than luck to determine the Fed's trend-setting interest rate. As a matter of principle, it should be less pretentiously heroic, less dramatically theatrical. As a matter of fact, it should be - in some fundamental way - more natural.


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