January 2008 update

The following sums up the mainstream approach:

Low inflation is a NECESSARY condition for optimal long term growth and employment.

There is not trade off. If a CB acts to support near term output, and allows inflation to rise, the longer term cost to output of bringing down that inflation is far higher than any near term gains in output.

The evidence of excessive demand is prices. So the way the mainstream sees it, currently demand is sufficiently high to support today’s prices of fuel, food, gold, and other commodities, as well as CPI in general.

In the first instance, price increases are ‘relative value stories.’ The negative supply shocks of food, fuel, and import prices are shifts in relative value, and not inflation. However, should the Fed ‘accommodate’ those price increases, and allow inflation expectations to elevate and other prices to ‘catch up,’ the Fed has allowed a ‘relative value story’ to become an ‘inflation story.’

Therefore, to optimize long term employment and growth, the Fed needs only to conduct a monetary policy that targets low inflation, and let markets function to optimize long term employment and growth.

There’s the rub. The Fed has been concerned about ‘market functioning.’ The mainstream understanding assumes markets are
‘functioning’ (and competitive, but that’s another story). If markets are not functioning there is no channel to translate low inflation to optimal growth and employment.

Hence the Fed concern for ‘market functioning.’ Unfortunately, there isn’t much in the literature to help them. There’s nothing, for example, that tells them what transactions volumes, bid/offer spreads, credit spreads, etc. are evidence of sufficient ‘market functioning.’ Nor do they have studies on which markets need to function to support long term output and growth. For example, are the leveraged buyout markets, CMO and other derivative markets supportive of optimal growth? And what about markets such as the sub prime markets that added to demand for housing, but may be unsustainable as borrowers can’t support payment demands? And meaning all they did was get housing subsidized by investor’s shareholder equity.

On Sept 18 the Fed cut rates 50 basis points citing risks to ‘market functioning.’ Given the above, this was a logical concern,
particularly given the lack of experience with financial markets of the FOMC members.

In the latest minutes, a different story seems to be emerging. Markets are now pricing in rate cuts based on the risks of a weakening economy per se.

While it is generally agreed that markets are now functioning (there are bid/offer spreads, and sufficient trading is taking place to
support the economy at modest levels of real growth) the concern now is that higher prices for fuel, food, and imports, higher credit thresholds, falling home prices, and a host of other non ‘market functioning’ issues, might reduce growth and employment to recession levels.

This view has no support in mainstream economic theory. As above, mainstream math- and lots of it- concludes that any level of demand that is driving inflation higher is too much demand for optimal long term growth and employment. If that means recession in the near term, so be it. The alternative is perhaps a bit more short term growth, but at the risk of accelerating inflation which will cost far more to bring under control than any possible short term gains. As Fed Governor Kohn stated, “We learned that lesson in the 70’s and we’re not going to make that mistake again.”

To be continued.