The Federal Reserve’s inflation error

Gerard Jackson
BrookesNews.Com
Monday 4 December 2006

The idea is taking root among the world’s economic commentariat that a country can not only manage creeping inflation but such a policy is actually necessary to promote and maintain economic growth. This has led to the idea that the Federal Reserve should implement a policy goal of an underlying inflation rate of 2 to 3 per cent a year is neither radical nor new. It is the same policy that eventually gave the US double digit inflation in the 1970s and early 1980s and will do so again if left unchecked. (The same nonsense is also preached in Australia)

Let us go back to a 1952 article by Sumner H. Slichter (a Harvard professor) and published in Harper’s Magazine. Calling the article How Bad is Inflation, he attacked as “uncritical and almost hysterical” a distinguished group of economists who warned that “inflation is a threat to the stability of the American economy and the security of the Western world”. Slichter argued that a rising price level, of say 2 to 3 per cent, is essential for prosperity. As Dr Winfield Riefler of the Federal Reserve pointed out at the time, even if an inflation rate of 2 per cent a year could be controlled “it would be equal to an erosion of the purchasing power of the dollar by about one-half in each generation”.

We should not forget that inflation can only do its ‘work’ if it is unforeseen. Once people realise that a certain rate of inflation has been planned they will take evasive action; unions will plan on inflation adjusted wages, and then some; businesses would increase prices in line with the planned rate of inflation, lenders would raise the interest rates, investors demand greater returns etc. Even so, the pernicious effects of inflation would still impact on the capital structure.

When anti-inflationists warned Slichter of the consequences of creeping inflation he replied that it is wrong to believe that creeping inflation is bound sooner or later to become galloping inflation. In 1957 he was still arguing that creeping inflation could be controlled. Twenty years later, inflation was galloping ahead at 13 per cent per year. The Carter presidency saw inflation wipe out over 40 per cent of the dollar’s purchasing power. So much for Prof. Slichter’s sanguine views on creeping inflation.

A vital component of the creeping inflation debate that is overlooked is that inflation discoordinates the market process by misdirecting production. Eventually, those lines of production that owe their existence to inflation will require larger doses of monetary injections to prevent them from abandoning labour and capital. The effect will be an escalating money supply and accelerating inflation.

The tragedy is that though the case for creeping inflation has been thoroughly discredited by economic history and sound economic theory it is still being successfully propounded as a responsible economic policy.

Gerard Jackson is Brookes’ economics editor