By Terry Connelly, dean emeritus of the Ageno School of Business at Golden Gate University
For the first time in a long time, the U.S. Federal Reserve Board's monetary policy is specifically focused on generating an increase in price inflation in order to contribute to economic recovery. The Fed's new posture flies in the face of the traditional explanation of the main purpose of having a Federal Reserve Bank with control of interest rates in the first place -- namely, that it is the Fed's job to "take away the punch bowl" just when the party's getting going.This is just a colloquial way of expressing the traditional view that (desirable) economic expansion, driven by an excess of demand over supply, unfortunately also contains seeds of its own destruction in the tendency for prices to rise in those circumstances to levels that eventually will slow economic activity by the "demand destruction" effects of those price increases. Better to nip such inflation "in the bud" by raising the cost of (and thereby reducing the temptation to) borrow money to feed demand further.
We have seen how the increasing price of gasoline at the pump — perhaps driven by supply shortages or fear of conflict breaking out in the Middle East oil patch — gets to a point where drivers reduce their driving. But this example of inflation producing of "demand destruction" actually seems to lead to more economic growth, not less, as drivers spending less fueling their cars as the price at the pump drops with lower demand have more to spend in their roles as consumers of goods and services, which drive 70% of the U.S. economy!
Perhaps observing this basic facet of economic activity in our developed economy, the Fed seems to have concluded that inflation is a two-edged sword, or indeed even a multi-faceted instrument that can have positive as well as negative effects on economic growth.
A New Mandate
But keeping a lid on inflation is no longer the Fed's only statutory mandate. Fed Chairman Volcker whipped inflation by shrinking the money supply, allowing short term interest rates to spike to the mid-teens and thus sharply restricting credit to put the nation's borrowing binge on a "cold turkey" diet — using higher rates to ultimately bring inflation down to levels consistent with a healthy growth rate, but not more.
In the early stages of the Great Recession, the Fed did take note of the increasing risks of literal "deflation" — where prices don't just rise at much slower rates but actually fall more or less across the board in the wake of sever credit contraction. This created the now-famous "negative feedback loop" where expectations of lower prices slow economic activity even further. Buyers of nearly everything think "I can get it cheaper, later" and so factory output tumbles in turn and the whole thing spirals downward with no self-correcting mechanism.
Indeed, the latter point was the main risk the Fed addressed when it cut short rates functionally to zero and started its first rounds of "quantitative easing" bond buyer— namely, that unlike inflation, deflation has now inherent self-correcting capacity, and once it takes hold, the Fed has few tools effective to stop it.
The Unemployment Effect
While net private sector hiring has been growing in fits and starts for over two years while government-based jobs have continued to disappear, the overall effect has resulted in unemployment and workforce participation rates stabilizing at levels nowhere near the Fed's mandate for full employment. The Fed has few if any direct tools to leverage private sector hiring, especially when it has already cut short-term credit rates to zero and extended them almost indefinitely.
But Chairman Bernanke has reckoned that the Fed does have indirect tools to drive employment, and convinced enough of his brethren to agree to put them to work specifically by a program of unlimited purchases of mortgage-backed bonds to take advantage of the multi-faceted aspects of inflation and inflationary expectations on economic activity — so long as one can keep them somewhat in check.
It is a tricky strategy to accomplish. On the one hand, the Fed knows its bond purchases will fuel a certain amount of increased inflationary expectations — the usual charge when it "prints money' that will actually drive longer term interest rates up for a time. And the 10-year bond, which has already dropped in price as their interest yield has climbed, are one of the key benchmarks in setting mortgage rates! How does this help spur home-buying?
Inflation Isn't the Issue
But the Fed also knows that inflation right now is pretty well controlled (except for time-bound factors driving food cost up and gasoline cost up ... and now back down), and bond prices have been historically very cheap, so it has room to maneuver on these fronts. As well, it believes that the decline in bond prices will move investors into riskier assets like stocks that drive 401(k) and IRA wealth effects. Consumers who at least feel richer tend to spend more, driving factory activity back up and service hiring as well.
Moreover, the Fed believes its purchases of mortgage-backed bonds directly will hold down the effects of rising 10-year Treasury yields to levels that still make home-buying and refinancing highly attractive. Especially if consumers are feeling the wealth effect of increases in the mutual funds and upticks in hiring that will only be enhanced by further progress in the emerging recovery in home prices. Again, with mortgage rates already at historic lows lie bond prices, the Fed sees room to maneuver before things get out of hand. And by continuing "operation twist" alongside its mortgage-bond buying, the Fed is continuing to "take duration" out of the bond market, the Fed is encouraging a "risk on" appetite among investors, invoking the "animal spirits" that some commentators generally critical of the fed believe are the prerequisite to a strong economic recovery.
It's all very tricky, this Fed plan of using a little targeted inflation to spur a miraculous economic expansion. Not the usual formula. But as the Fed tries an untested and unprecedented plan to re-animate the economy in a way that honors its dual mandate, we can perhaps recall the famous exclamation of Gene Wilder as "Young Frankenstein," as he contemplates his own scheme to fulfill his dead grandfather's dream of re-animating the monster's lifeless tissue: "It Could Work!"
Terry Connelly is an economic expert and dean emeritus of the Ageno School of Business at Golden Gate University in San Francisco. Terry holds a law degree from NYU School of Law and his professional history includes positions with Ernst & Young Australia, the Queensland University of Technology Graduate School of Business, New York law firm Cravath, Swaine & Moore, global chief of staff at Salomon Brothers investment banking firm and global head of investment banking at Cowen & Company. In conjunction with Golden Gate University President Dan Angel, Terry co-authored Riptide: The New Normal In Higher Education.
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