Alan Reynolds

A bond trader is quoting fearing a 2.5 percent fed funds rate by the end of 2005. I'm sure the fed funds rate will be higher than that next year, but that is right and good. If the Fed tried to keep the interest rate on bank reserves below 2 percent during a time of vigorous economic activity, they would have to buy gobs of Treasury bills and create new bank reserves to pay for them. Judging by past behavior, the Fed is more likely to slowly adjust the fed funds rate to keep pace with the year-to-year trend of spending -- nominal GDP -- which is already above 5 percent.

Brown says, "A period of weak growth, which would keep inflation in check, is possible." If the economy is strong, we will get higher inflation and interest rates and end up with a weak economy. If the economy is weak, we start with a weak economy. Either way, the economy can only be weak. This theory cannot even begin to explain how China mixes real economic growth of 9 percent with inflation of 1.8 percent.

The article mentions some facts: "So far, the market has shrugged off the declining dollar, rising commodity prices and big budget and trade deficits because the jobs market, until recently, was so weak." The idea that the stock market "shrugged off" warnings of inflation presumes the stock market goes down if inflation goes up. Ironically, The Economist was apoplectic in urging the Fed to tighten in the late '90s because stock prices were soaring. But stocks do suffer with serious inflation, which means inflation risk was low in the '90s and it is still low today.

The broad dollar index was around 116 in late 1999 when the Fed started raising interest rates, rose before and during the recession, and was back down to about 116 by late November. Whether the dollar is up, down or sideways depends on where you start. In any case, the post-recession decline of the dollar is relevant only to the extent that it might have inflated the prices of imports. In October, the yearly increase in import prices was only 0.9 percent, and even lower without oil.

Prices of industrial commodities are cyclical, so they bounced back with global economic recovery. In Europe and Japan, unlike China, the lower dollar has made commodities like oil and copper cheaper in terms of euros and yen. To the extent that the dollar's drop is not expected to last, it would pay European and Japanese to stockpile oil and other commodities priced in dollars. If China feels pressured to revalue the yuan, that too would foster stockpiling and result in higher commodity costs for U.S. industry. But stockpiling is a temporary phenomenon, and one-time price changes should not be called inflation.

Gold is different, because it is mainly held as an asset. If people are converting greenbacks to gold as a hedge against inflation, however, I would expect more speculation in the futures market. The last I looked, you could buy gold a year from now for only 1.5 percent more than today's price. That is a very low interest rate for holding gold.

The "big budget and trade deficits" are red herrings. If big budget deficits were inflationary, then Japan would be suffering hyperinflation. As for trade deficit, cheap imports are certainly not boosting the cost of living, but restricting them would.

That leaves wages. "Most experts," writes Brown, "the Fed included, believe the economy would need to create hundreds of thousand of jobs -- as many as 150,000 to 200,000 a month for the better part of a year -- for any inflationary pressure to rise." I don't know how he could know what most experts believe, but that is not it. Inflation happens when the Fed supplies more dollars than people feel secure about holding, so they offer more and more dollars for fewer and fewer goods. If we needed low unemployment to have high inflation, then the horrible stagflations of the '70s could never have happened.

The reason labor costs are down and profits are up is not because unemployment kept pay down but because of efficiency and economic recovery. Between the third quarters of 2002 and 2003, compensation in U.S. manufacturing industries rose by 4.4 percent, yet labor costs did not rise -- because output per hour rose 4.4 percent.

There may be good reasons to be concerned about inflation in the years ahead, but much of what I have seen about this topic so far appears to be based on questionable theories and unpersuasive facts. Inflation is always worth watching, and certainly worth preventing with sensible Fed policy. But if worry is the actual objective, there must be things to worry about.

Alan Reynolds

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