May
16, 2004
Low Rates, High Expectations
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I
Why the Fed decided to propagate
inflation, after having so long battled against it, is a story that begins with the return
to common usage of an old word. Late in 2002, officials began to warn of the danger of
"deflation," or broadly falling prices. Everyday low prices are well and good,
the central bankers allowed. Yet if prices steadily and predictably fell, people would
stop buying things. They would stay home to wait for tomorrow's guaranteed lower prices.
And if the American consumer stopped shopping — and borrowing to shop —
where would we be?
So, last June 25, the Fed pushed the
federal funds rate, the rate it directly controls, down to 1 percent, the lowest since the
second Eisenhower administration. And it warned that "the probability, though minor,
of an unwelcome substantial fall in inflation exceeds that of a pickup in inflation from
its already low level."
Before the Fed was founded, in 1913,
there were recurrent cycles of inflation and deflation. In general, prices rose in wartime
and fell in peacetime. In the last quarter of the 19th century, prices persistently fell.
Technological innovation pushed down costs, and lower costs translated into lower prices.
Wage-earners flourished as the spending power of money increased. Creditors prospered,
too, as interest rates declined.
Then, about 1900, the world struck
gold — in Alaska, Colorado and South Africa. As gold was then the monetary
asset on which national currencies were based, the world, in effect, struck money. For the
next two decades, prices went up.
It is a relatively new thing in
finance that prices should not be allowed to fall. The Federal Reserve implicitly admits
as much. On the one hand, it extols the rising productivity of the United States economy.
On the other, it declares that this extraordinary progress should not be registered in
falling prices. In so many words, the central bank says that what is good for Wal-Mart's
customers is not necessarily good for the country.
The Fed doesn't literally print
money. Instead, it manipulates the interest rate that induces others to print money. In a
modern economy, money-printing takes the form of credit creation, i.e., lending and
borrowing.
There has been a great deal of this
in recent years. By any and all measures, America is more heavily indebted than ever
before. In 1958, when the funds rate was last at 1 percent, the economy's overall
indebtedness was about half of today's. Back then, overall debt (excluding the borrowings
of banks and the federal government) represented 84 percent of gross domestic product.
Nowadays, it stands at 163 percent of G.D.P.
The weight of this indebtedness,
foreign as well as domestic, helps to explain why the Fed set its rate so low. One percent
is an emergency rate, unseen before the institution of the Fed and only rarely since. It
was the rate intended to raise the economy from the Great Depression and to see it through
World War II and the immediate cold war era.
The Fed chairman, Alan Greenspan, and
his colleagues keep saying that there is no emergency — that, on the
contrary, the United States economy is a paragon of strength, lacking only an acceptable
rate of job creation. Yet they have kept their rate at the emergency setting, thus
fomenting a real-estate boom on Main Street and a stock-and-bond boom on Wall Street.
Now the 1 percent era is fast
closing, and financial markets worldwide are shuddering. As the signs of inflation
multiply, the Fed finds itself in a very interesting position. It never wanted much
inflation, it protests; just a whiff would suffice.
But the subjects in the central
bank's monetary experiment are human beings, not laboratory mice. When people sense that
prices are going to rise, they take steps to protect themselves. They buy extra inventory,
invest in so-called hard assets (houses, not bonds) and pass along their rising costs as
best they can. Once instilled, inflationary habits are hard to break, as the Fed exactly
understands.
And the Fed will raise its rate,
though grudgingly and gradually. It will act in this fashion not only out of conviction
but also, perhaps, out of a guilty conscience. It knows that its 1 percent rate drove many
risk-averse people into stocks and bonds because they could no longer afford to live on
the meager returns of their savings. That is at one pole of the spectrum of financial
sophistication. At the other, hedge funds borrowed at ultra-low rates to speculate in
everything from gold to lead. Just the prospect of a slightly higher borrowing rate has
brought about disturbances in the temples of high finance.
The Fed has another reason to be
conscience-stricken. It knows, or should know, that by trying to make the dollar cheaper,
it has precipitated even more borrowing in an economy heavily encumbered. The greater the
debt, the more deflation-prone the economy. And the more deflation-prone the economy, the
more the Fed is apt to try to cheapen the dollar. The truth is that the central bank of
the United States is chasing its tail.
James Grant is the editor of
Grant's Interest Rate Observer; www.grantspub.com
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