Killing inflation

The Fed is making a bet. Perhaps the biggest bet in the world.

Many people wonder what the Fed does and why it does it. And what happens if the Fed makes the wrong move.

As you know, the Fed has been raising short-term interest rates. For about two years, it has pushed the interest rates upward. For the moment it has stopped pushing up rates.

Central banks around the world have been raising interest rates. Some more, some less.

Why is the Fed doing this?

It is trying to slow down inflation. It sees inflation in various corners of the economy. It knows inflation is ruinous. The Fed may be to blame for some or all of the inflation. It wants to stop or slow it.

And therein lies the bet. The massive bet.

The Fed has been raising rates. The higher rates have helped put the brakes on the economy. Higher rates often do that. They raise the cost of doing business. At the higher cost, fewer people do business.

From what some of the Fed people have said, the Fed is betting that the slowing economy will slow inflation.

The Fed stopped raising rates even though inflation is still rising. ďBut if the economy keeps slowing it will do our job for us. By slowing, it will take the steam out of inflation.Ē In other words, fast growth in the economy causes inflation. Slow growth will reduce inflation. That is the Fed thinking. That is the bet.

There is a small problem with this bet. History does not look kindly upon it.

The Fed used to think this way. And act this way. The result was miserable. We suffered high inflation (in the 70ís) and very slow growth. Otherwise known as stagflation. The Fed kept expecting the slow growth would cut off inflation at the knees. And that if we perked up the economy we would simply increase the inflation.

Along came economist Milton Friedman. Actually, he had been around for a long time. But the Fed and others had dismissed what he had to say.

What he said was that a hot economy does not cause inflation. Too much money does. The Fed was creating too much money. It does this in lots of ways we donít need to get into. Point was, the economy was awash in money. Too much money - chasing too few goods - causes inflation.

Paul Volker came to the Fed and put Friedmanís ideas into practice. He sucked in the excess money. Reagan approved. This crimped the economy. It caused a major recession. But it killed off inflation for many years to come.

If Volker was around today and followed the same policy, he would not have let the Fed increase the money supply so much a few years back. He would also have the Fed suck in the excess money, using higher rates. He would probably be causing a recession. But he would be killing inflation.

I hate to see the Fed bet that growth causes inflation. I hate to see it bet that excess money creation does not. I hate to see it bet that a slowing economy will erase inflation. I hate to see these bets because the Fed and the country lost these same bets 35 years ago.

From Tom ... as in Morgan.

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