Several of the wisest economists and editorial writers I know are recommending that the Federal Reserve should keep raising interest rates until ... until what? Until something bad happens?
Central banking is the last refuge of central planning -- the notion that a group of experts can meet in secret and plan the economy from the top down. But this is a game played without any rules. We speak of the "art of central banking," as though it is akin to a magic show. So long as a central bank doesn't mess up too badly, we tend to almost deify central bankers. When they do mess up, many then argue that we must have deserved the pain and suffering as penance for the good times.
One well-known problem with this magic show is called "recognition lag," and it often results in "overshooting" -- pushing interest rates too high or too low for too long. Look carefully at the reasons given for Fed decisions, and you will find they always refer to something that happened in the past. Economic growth looked fine last year or last quarter, for example. This is like speeding down the highway while trying to steer your car by gazing in the rearview mirror -- to see if you're staying inside the lines.
For mysterious reasons, these speeding, backward-gazing magicians prefer to focus on past news about the real economy, rather than growth of inflation or nominal spending. The inference is that vigorous growth must be inflationary and that weak growth ensures weak inflation. Yet inflation has always gone up whenever economic growth turned flat or negative -- in 1974-75, 1979-81, 1990 and even 2001.
Nobody knows what the Fed will do next, or why. But I do know what happened in the past under eerily similar circumstances. Every recession in the past 30 years has been preceded by a confluence of four events, three of which may have been avoidable:
First of all, energy prices were rising rapidly before every recession. Within the consumer price index (CPI), energy prices rose 8.1 percent in 1973 and 29.6 percent in 1974; 25.1 percent in 1979 and 30.9 percent in 1980; 5.6 percent in 1989 and 8.3 percent in 1990; and 16.9 percent in 2000.
Aside from 2000, inflation in general was terribly high even before those previous energy price spikes -- the non-energy CPI rose 7.8 percent in 1978 and 4.4 percent in 1988. After oil prices spiked, however, the non-energy CPI always slowed rather than accelerated for a few years. There is no evidence that energy price spikes have ever led to higher non-energy inflation. That's a dangerous myth.
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