In other words, the cause of inflation is exactly opposite from what Keynesians believe. Supply-side experience informs us that the prescription for shutting off inflation is not to take action like raising taxes to slow economic growth, but rather to reduce excess liquidity in the Federal Reserve Board's portfolio to the point that it is sufficient to keep the economy running at peak performance. Another beneficial byproduct of getting the liquidity level right is that the value of the dollar will automatically return to equilibrium, providing a correct "unit of account," a numeraire.
That's why it is so important for the Bush administration and Alan Greenspan's Fed to pay attention to inflation indicators earlier rather than later before they sprout into higher prices and a full-blown dollar crisis. Some of the classic warning signs of inflation are flashing but not because the economy is growing too fast. The price of gold broke the $400-per-ounce barrier and closed the week at $406. The CRB commodities price index of price-sensitive commodities is up 36 percent from its low point - although that low was reached during a deflationary recession. The trade-weighted exchange value of the dollar has fallen 20 percent from its top, which was not unexpected. The Producer Price Index has been steadily rising since May 2002, and even the lagging Consumer Price Index has begun to rise.
It is vital for policymakers to see these signals for what they are and to understand what is occurring. The inflation signals are coming during a period of fundamentally sound rapid economic growth, and they are occurring concurrently with a sinking dollar - a portion of that decline having been engineered by the administration's threatening and jawboning other countries about the values of their currencies. Unless the Fed and the Bush administration recognize what is going on and take corrective steps now, they could find themselves feeling politically compelled to pursue exactly the wrong policies - raising taxes, manipulating interest rates and intervening into foreign currency markets in a counterproductive attempt to strengthen the dollar.
It is time for the Fed to sell bonds and drain excess liquidity until inflation signals fade and announce a price-rule for the dollar that seeks neither a strong dollar nor a weak dollar but a stable dollar as a unit of account. If it does, short-term interest rates will rise. Long-term interest rates, however, which already exceed short rates by 400 basis points, wouldn't rise much, and growth would continue apace.
In addition, the Bush administration should cease its weak-dollar rhetoric and come to the realization that the only effective way to increase manufacturing activity and exports over the long run is to lower tariffs and continue the drive to lower tax rates on labor and capital. Economic growth will do the rest. It may be the same old supply-side prescription, but experience has provided empirical evidence both to its rationale and efficacy.