| STEVE H. HANKE | Steve H. HANKE |
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CONTRIBUTING EDITOR Professor of Applied Economics at the Johns Hopkins University & Columnist at Forbes magazine |
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The Fed’s Zigs and Zags |
Mr. FISHER concluded that this was a mistake caused by faulty statistics. The Fed’s favorite measure was underreporting inflation from late 2002 through early 2003. According to Mr. FISHER, bad data caused the Fed to push interest rates too low and to keep them there for too long, adding fuel to the housing and commodity market booms.
If nothing else, Mr. FISHER’s diagnosis of the recent past is yet another good reason to dust off the works of economists from the Austrian School, particularly Friedrich von HAYEK’s. The main lesson from the Austrians was their extreme skepticism about the exclusive reliance on one magic index—the price level—to guide central bank policy. Indeed, von HAYEK stressed that changes in general price indices don’t contain much useful information. He demonstrated that it was the divergent movements of different market prices during the business cycle that count. Even a casual review of prices for different commodities, goods and services, as well as assets and the value of the dollar, would have enabled the Fed to avoid its mistake.
To understand where we are and where the Fed might be going, let’s look at the entire Greenspan era: were there other mistakes or perverse policy patterns between August 1987 and January 2006? The easiest way to do this is to measure the trend rate of growth in nominal final sales to domestic (U.S.) purchasers and then examine deviations from that trend. During the Greenspan era, nominal final sales grew at a 5.4% annual rate, with real sales growth accounting for 3.0% of the total and inflation 2.4%.
The first deviation from the trend in final sales (demand) began shortly after Alan GREENSPAN became Chairman. In response to the October 1987 stock market crash, the Fed turned on its money pump, and over the next year final sales shot up by 7.5%, well above the trend rate of growth. The ensuing Fed tightening produced a mild recession in 1991.
From 1992 through 1998, the nominal value of final sales was quite stable. But the 1997-98 Asian Financial Crisis, the collapse of Long Term Capital and the drubbing of the Russian ruble in 1998 and Brazil’s devaluation in 1999 triggered another excessive Fed liquidity injection and a boom in nominal final sales. This was followed by another round of Fed tightening, which coincided with the equity bubble burst in 2000 and a near recession in 2001.
The last big jump in nominal final sales was set off by the Fed’s liquidity injection to fend off the false deflation scare in 2002. And, like night follows day, the Fed started putting on the breaks in 2004 and final sales are rapidly slowing, with growth over the past year at 5.0%.
The Fed’s zigzag pattern is clear: an overreaction to a so-called crisis, resulting in the excessive injection of liquidity (a sales boom) followed by a slow draining of liquidity and a mild recession (sales slump).
The problem for investors this time around is that the economy is only starting to search for a bottom. But, even after the Wall Street selloff of February 27th, you wouldn’t know it by looking at the way risks are priced. No matter what market you look at, there is still very little provision for risk.
