Fed policy should focus on price stability

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Ben Bernanke and his buddies at the Federal Reserve have half the economic equation right. But the half they’ve got wrong could turn out to be quite costly.

In the Federal Open Market Committee statement released Nov. 3, the Fed reiterated concerns over a slow recovery in output and employment; consumer spending being restrained in part due to high unemployment and modest income growth; a slowdown in business spending on equipment and software; weak investment in nonresidential structures; housing still being depressed; and employers reluctant to add jobs.

Indeed, the U.S. economy continues to grossly under-perform.

At the end of last month, the Bureau of Economic Analysis released its advance estimate of third quarter real GDP growth. It came in at 2.0 percent, barely ahead of the 1.7 percent rate in the second quarter.

Consider that since 1950, annual real GDP growth has averaged 3.4 percent. Over these past two quarters, growth averaged a mere 1.85 percent.

Since the current recovery supposedly got under way in mid-2009, real growth has averaged only 2.8 percent. That’s a bit better. But consider where growth should be during recovery/growth periods. Factor out recessions, and real GDP growth has averaged 4.5 percent since 1950 during recovery/growth quarters.

People feel like this is a dismal economic recovery, and that’s confirmed by the numbers.

Unfortunately, dig deeper, and the news gets worse. GDP quality matters. That is, high-quality economic growth springs from the private sector, driven by entrepreneurship, investment, consumer choice and competition, as opposed to government’s share of GDP, with decisions guided by politics and special interests.

Unfortunately, once one factors out government’s contribution to real GDP growth, it turns out that private GDP grew at only 1.3 percent in the third quarter and 0.9 percent in the second quarter. The harsh economic reality is that the private sector has been barely staying ahead of a double-dip recession.

But while the Fed is correct to be worried about the state of the economy, its proposed remedy has been and continues to be way off base.

Bernanke & Company opened the monetary floodgates in September 2008. The monetary base (currency plus bank reserves), which the Fed has direct control over, exploded by 150 percent from August 2008 to February 2010. Such a massive monetary expansion is without precedent in our nation.

Interestingly, a slight reining in of monetary policy occurred from February through September. But the Fed’s November statement makes clear the monetary policy floodgates will be opened still wider.

The FOMC said: “To promote a stronger pace of economic recovery and to help ensure that inflation, over time, is at levels consistent with its mandate, the Committee decided today to expand its holdings of securities. The Committee will maintain its existing policy of reinvesting principal payments from its securities holdings. In addition, the Committee intends to purchase a further $600 billion of longer-term Treasury securities by the end of the second quarter of 2011, a pace of about $75 billion per month.”

The Fed believes that still looser monetary policy will somehow get the economy back on track. But how exactly would that work? Could interest rates actually be pushed any lower? After all, the federal funds rate is targeted at zero percent to one-quarter percent. A tiny reduction in interest rates from the current low levels will make no difference.

As should be apparent from the past two-plus years, monetary policy is not the right policy tool to aid economic growth and job creation. The Fed has been pressing the monetary policy accelerator to the floor, yet the economic engine continues to sputter and stall. Pushing even harder will accomplish nothing.

Well, at least nothing positive.

The enormous risk is inflation. In fact, the Fed chairman recently declared that inflation was too low, and the FOMC statement makes clear the Fed has adopted the old mistaken belief that a bit of inflation can help fight unemployment.

But no evidence exists to support the Phillips Curve notion of a trade-off existing between inflation and unemployment. One would have thought that the stagflation of the 1970s and very early 1980s confirmed the fallacy of this theory. It’s downright scary that the Federal Reserve still toys with such a bankrupt idea.

So, the Fed is adding to the potential economic ills. Rather than pulling in its recent monetary mistakes to perhaps stave off or limit the damage from future inflation, the Fed is moving in the exact opposite direction by further pumping up both monetary growth and inflation risks.

As the great, late economist Milton Friedman summed up, “Inflation is always and everywhere a monetary phenomenon.”

What the U.S. economy needs is straightforward. Monetary policy should be focused on maintaining price stability. That’s all monetary policy is good for. Meanwhile, Congress and the White House need to rein in the size of government to free up resources for the private sector, and implement deep, broad-based tax and regulatory relief to boost incentives for investment and entrepreneurship, which in turn drive economic growth and job creation.

Unfortunately, monetary, spending, tax and regulatory policies have been pointed in exactly the wrong direction. The big question: Will this change with the historic shift that occurred on Nov. 2 at the ballot box?

Raymond J. Keating, chief economist for the Small Business & Entrepreneurship Council, can be reached at rkeating@sbecouncil.org. His new book is titled Warrior Monk: A Pastor Stephen Grant Novel.