BrookesNews.Com
Monday 14 May 2007
Recently some Federal Reserve officials such as Mishkin, Fisher, Lacker, Moskow and Poole have voiced their support for setting inflationary targets. It is held that this will not only stabilise the rate of inflation but will also help to stabilise economic activity around sustainable levels. In short, setting targets could in fact eliminate the menace of boom-bust cycles.
According to this way of thinking a weakening in the overall demand for goods and services lowers the overall output. Also, as a result of a decline in the overall demand for goods and services the rate of inflation falls below the target set by the Fed. (Fed officials regard this target as consistent with price stability).
In order to maintain the inflation target the Fed loosens its monetary stance i.e. lowers the interest rate and pumps money into the economy. This in turn stimulates the demand for goods and services. Consequently, producers abide by this increase in demand and raise the production of goods and services — an increase in the overall output emerges. As a result of the increase in the overall demand for goods and services the fall in the rate of inflation is also reversed and it is now moving back towards the target set by the central bank.
Note that the policy of adhering to the inflation target has not only stabilised the rate of inflation but it also raised the rate of growth in the overall output, which is consistent with price stability, so it is held. When the economy gets overheated and the rate of inflation rises above the target the Fed steps in and “cools off” the economy by a tighter monetary stance. This lowers the demand for goods and services and brings the overall demand in line with the economy’s potential output. As a result of this the rate of inflation falls back to the target in line with the policy setting of the Fed.
Again the policy of maintaining the rate of inflation in line with the inflation target leads to price stability and to the rate of growth in real output, which is consistent with price stability. This way of thinking was neatly summarised by a governor of the Federal Reserve Frederic Mishkin in his speech on April 10 2007.
To see further how this process would work, consider a negative shock to aggregate demand (such as a decline in consumer confidence) that causes households to cut spending. The drop in demand leads, in turn, to a decline in actual output relative to its potential, that is, the level of output that the economy can produce at the maximum sustainable level of employment. As a result, future inflation will fall below levels consistent with price stability, and the central bank will pursue an expansionary policy to keep inflation from falling. The expansionary policy will then result in an increase in demand that raises output back up to potential output in order to return inflation to a level consistent with price stability.
For example, during the last recession the Federal Reserve reduced its target for the federal funds rate a total of 5.5 per centage points, and this stimulus not only contributed to economic recovery but also helped avoid an unwelcome further decline in inflation. In other cases, a tightening of the stance of monetary policy is needed to prevent an “overheating” of economic activity, thereby avoiding a boom-bust cycle in the level of employment as well as an undesirable upward spurt of inflation. (Remarks by Governor Frederic S. Mishkin at Bridgewater College, Bridgewater, Virginia, April 10, 2007. Monetary policy and the Dual Mandate).
Let us examine the logic of this framework of thinking. Can the Fed lift overall output by stimulating the demand for goods and services by means of lowering interest rates and monetary pumping? In this way of thinking demand appears to be the limiting factor. But is it true? We suggest that there is never a problem with demand for goods. The problem is how to pay for various goods and services that individuals desire to have. For instance, an individual may have a demand for Mercedes 600 however, the means at his disposal only allow him to have a bicycle. So how could loose monetary policy increase people’s ability to buy goods and services?
Funding and money — what is the difference?
Take for instance a baker, John, who has produced ten loaves of bread. He consumes two loaves and the rest i.e., the eight loaves of bread he uses to exchange for other consumer goods like vegetables and fruits. Observe that John funds the purchase of fruit and vegetables by means of bread he has produced and saved. Likewise saved fruits and vegetables enable the fruit and vegetable farmers to fund their purchases of bread.
The means of funding, or the pool of funding in our example, is comprises of bread, fruit and vegetables i.e. saved final consumer goods that promote and enhance people’s life and well beings. (Note that the bakers’ contribution to the pool is eight loaves of bread i.e. ten produced loaves minus two loaves that the baker consumes). What permits the expansion of the pool of funding is an increase in the quantity and the improved quality of various tools and machinery. With a better quality and a greater quantity of tools and machinery a larger amount and a greater variety of final consumer goods can be produced — an increase in people’s living standards emerges.
The portion of the pool of funding that individuals are allocating towards the making of tools and machinery is the ultimate driving factor for the expansion of wealth. If individuals were to decide to allocate their entire pool of funding towards the production of final consumer goods then we would not have the increase in the stock of tools and machinery. Consequently, it will not be possible to increase the pool of funding.
For instance, rather than exchanging the eight loaves of bread for vegetables and fruits the baker may decide to enhance his oven by hiring the services of a technician. In other words rather than securing other consumer goods the baker invests his bread in the enhancement of the oven, which hopefully will lift the daily production of bread.
The technician is here supported i.e. funded by the eight loaves of bread. His services enable him to secure the final consumer good – bread which sustains the technician’s life and well being. With an improved oven John can now produce twenty loaves of bread. This, assuming he still only consumes two loaves, allows him to save eighteen loaves, which can be used to acquire a greater variety of other consumer goods. It will also enable John to make another investment and raise his living standard further.
(Incidentally, when the baker pays with his loaves of bread for final consumer goods he in fact funds so to speak the production of final consumer goods. Thus the bread that the fruit and vegetable farmers are securing from the baker sustains them with other final consumer goods whilst they are continue in their production of fruit and vegetables).
The introduction of money doesn’t alter the essence of what was said so far — namely that what funds the demand for goods and services is saved final consumer goods and services. Individuals pay for various goods and services by means of final consumer goods and services. When a baker exchanges his eight loaves of bread for eight dollars and then exchanges the eight dollars for fruit and vegetables it doesn’t follow that he paid for fruit and vegetables with money. The baker pays for fruit and vegetables with his saved bread. Money is used here just to facilitate the transaction - to make the payment for fruit and vegetables by means of bread possible.
Can the expansion in the money supply give rise to a greater production of final consumer goods? If anything the pumping of money and the lowering of interest rates will make things much worse. For instance, by diverting final consumer goods to themselves by means of new money and offering nothing useful in return the holders of the new money will leave less bread, fruit and vegetables for the baker and other producers thereby curtailing their ability to generate wealth.
In brief, the expansion in money supply results in an exchange of nothing for something — and that leads to an economic impoverishment. So if loose monetary policy cannot generate economic growth how is one to reconcile governor’s Mishkin comment that the lowering of the federal funds rate target from 6.5% in January 2001 to 1% in June 2003 managed to lift economic growth.
(Remember that the economic growth that Mishkin refers to is in terms of GDP, which is just monetary turnover. This means that the more money is pumped the greater the GDP is going to be and hence also the greater so-called economic growth is going to be).
The yearly rate of growth of real GDP jumped from 0.2 per cent in Q4 2001 to 4.5 per cent by Q2 2004.
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Even if we were to accept that an increase in GDP might be indicative of an increase in real economic growth what does all that have to do with the Fed’s policy? As we have seen what permits real economic growth is a growing pool of funding. Funding cannot be created by means of loose monetary policy. If this could have been done then worldwide poverty would have been eliminated a long time ago. (If one wants a good example of why loose monetary policy creates poverty have a look at Zimbabwe’s economy).
What loose monetary policy can produce during a recession or an economic slowdown is an artificial stimulus, which provides support for various wealth consuming activities. These activities in turn dilute the pool of funding thereby weakening the prospects for real economic growth. As long as the pool of funding is expanding the increase in monetary pumping can generate an illusion that the central bank can grow the economy. Once however, the pool of funding stagnates or starts to shrink this illusion is shattered. A classical case in this regard is the US during 1930s and Japan during 1990 through to early 2000.
(Based on the past aggressive loose monetary policies we suspect that the US locally generated pool of funding is likely to be stagnant or even declining. Hence without the support from economies like China and the rest of the World the US would have been in a difficult economic situation a long time ago).
Recall that in his speech governor Mishkin has also suggested that if the economy gets overheated and this in turn causes the rate of inflation to rise above the target then the Fed should tighten its stance. In a free market economy where no one prints money and where individuals produce first before they embark on consumption no overheating can emerge. Overheating requires the emergence of an exchange where individuals exchange nothing for money and then exchange money for goods and services.
his as a rule takes place when the money supply is expanding. Once demand for goods and services, which is not supported by production arises, overheating, which takes the form of a general rise in prices, occurs. On account of monetary expansion various activities emerge on the back of this monetary expansion. Now, if the Fed tightens its stance to prevent overheating it is going to bust these activities. Note that what laid the basis for the bust is the Fed’s previous own loose policy put in place to prevent the rate of increase in the price level from falling below the target.
Summary and conclusion
To recap then, loose monetary policy that lifts the rate of inflation towards the target set by the Fed gives rise to various artificial forms of life — an economic boom emerges. As time goes by this results in the so-called overheating. Once the Fed tightens its stance “to cool off” the economy in order to bring the rate of inflation in line with the target this starts to undermine various artificial forms of life — an economic bust is set in motion.
We can thus conclude that contrary to Mishkin and other Fed officials setting and adhering to an inflation target will only de-stabilise the economy and make things much worse.
Dr Shostak is a former professor of economics who now works in the private sector