By WAYNE ANGELL
Wall Street Journal, December 16, 1997
The Federal Open Market Committee has never had
such a clear choice of policy philosophies. Today each of the 12 voting
members has to decide whether the best path to price stability is to target
the unemployment rate or to follow gold and commodity price signals.
Recent data show the two models providing starkly contrasting inflation
predictions.
A standard labor market tightness model, based on
the Phillips Curve's logic, suggests that the recent
fall in the unemployment rate to 4.6% is likely to
escalate the inflation rate to a range of 3% to 4%
over the next 24 months, from 2% today. By this
logic, the committee should raise its federal funds
target rate above the current 5.5% in order to
increase the unemployment rate and thereby slow
wage increases.
The model my colleagues and I use--relating the
price of gold at $285 an ounce to a 12-month trailing
rate of inflation--suggests consumer price inflation
is likely to fall to around 1.7% and a broader GDP
deflator measure of inflation will fall to a 1.5%
annual rate. FOMC members who follow this model would lower the fed
funds rate to lessen the risk that inflation falls too rapidly.
Just Right
My guess is that today the FOMC will leave the funds rate unchanged at
5.5%, a good choice. As Chairman Alan Greenspan has suggested, at this
stage of an expansion with tight labor markets, it pays to err on the side
of
restraint. Indications from the price of gold and other commodity prices
suggest that leaving the funds rate at 5.5% is doing just that.
If the Fed were to increase the funds rate to 6% or higher in order to
head
off a continued acceleration of wage inflation, the impact would not be
what
it intended. Interest rates would have to be increased significantly to
create
a higher unemployment rate. Unfortunately, seeking a level of interest
rates
that would slow employment growth would necessarily cause a slowdown of
new capital formation and thereby contribute to a decline in the growth
of
labor productivity.
The notion that inflation is caused by increasing wage rates is just plain
wrong. Employers are not paying higher wages out of generosity or out of
some social agenda, but precisely because their profits will be higher
if they
pay the rising market-determined wage rates.
Whenever a central bank such as the Federal Reserve focuses on
price-level stability, the economy and the tax system on capital becomes
more efficient, as less time is spent on speculative endeavors and more
time
is spent finding new ways to increase production. That means new
technology, new capital goods, and growth in labor productivity. What we
get is more rapid economic growth.
Therefore it is nonsense to suggest that the spur to growth stemming from
sound money is inflationary. Of course, an acceleration of economic growth
will lead to tighter labor markets and to higher wage rates. But higher
wages
do not imply an increase in the rate of inflation; new-age capital goods
enable employers to get the productivity increase that makes workers
profitable at higher wage rates. Thus the Fed need not be alarmed in 1998
as annual increases in average hourly earnings continue to rise as the
unemployment rate falls.
Mr. Greenspan is to be congratulated for having provided leadership
restraint--contrary to the suggestions coming from the
growth-causes-inflation crowd at the Federal Reserve and at the
International Monetary Fund. The FOMC has done well to resist
suggestions that its job is to restrain economic growth to a speed limit
of 2%
to 2.5%. There has been enough good economic news lately to make nearly
everyone happy: real economic growth of 4%, 38 million net new jobs in
the
past 15 years, an 8% surge of federal tax receipts to move the budget into
surplus in 1998, wage rate increases moving up to 4% from 2.5% while the
consumer price index has gradually declined to 2% from 4%. And indeed,
most everyone is better off--except the dismal economists who still believe
the Fed's job is to put a limit on growth.
Hardly anyone had dared to expect such outstanding results as have
accompanied the Fed's pursuit of gradual disinflation. When the FOMC first
laid out the case for zero inflation, most Fed watchers thought it could
not be
done. They thought the trade-off costs would be too high because they were
mesmerized by the prevailing notion that unemployment rates would have
to
rise. Not so: This period of gradual disinflation has been accomplished
while
the unemployment rate continued to fall from 6% to the current 27-year
low
of 4.6%.
The risk of inflation increases precisely when a central bank moves its
focus
away from price stability to faster economic growth. When monetary policy
switches to a pursuit of growth, producers are apt to feel free to experiment
with price increases, presuming that growth is guaranteed by the central
bank. That is what happened in the 1970s, when the Fed demonstrated it
would respond to higher oil prices by providing enough monetary liquidity
to
enable our economy to continue to expand. The clearest signal of the Fed's
policy error was the rise in the price of gold from $35 to $42, then to
$80,
$300, and finally $800 an ounce.
The decline in the price of gold to below $300 an ounce is the most
forward-looking indicator that parallels the view of manufacturers and
retailers that they have very limited pricing power. When consumers' trust
in
their money's value keeps them in a "waiting for a sale" attitude, producers
are not likely to believe that they can raise prices. Manufacturers and
consumers rarely buy and sell gold. But the price of gold gives us insight
concerning the future behavior of consumers and manufacturers because
holding gold as a store of value is a pure play on trust in the Federal
Reserve.
If the price of gold is a noteworthy signal, then at some point a decline
in the
price of gold would indicate that inflation rates are falling too rapidly.
Deflation risk to an economic system is not that commodity prices decline.
Commodity prices go up and they go down. But, when trend
commodity-price inflation accelerates to, say, 6% from 2%, people begin
making assumptions as to whether the acceleration of inflation will continue.
Expectations of higher commodity prices set up a leveraged rise in real
property prices. Farmland, office buildings, and oil and natural gas
leaseholdings soar in value. The easy money that set off the commodity
price rise also spurs commercial bankers to provide the credit that fuels
a
real property price bubble. When monetary restraint is applied, property
price deflation wreaks havoc on farm, energy and other
commodity-producer land owners, as well as on their bank lenders.
The 1985 fall in the price of gold to $280 per ounce was a leading indicator
of property price deflation. Today the price of gold at $285 per ounce
is not
an indication of another property price deflation. Somewhat moderate
property price increases are evident in nearly every type of property across
all regions of the country. Property prices do not reflect a preceding
period
of easy money and easy credit. Generally, an easy credit bubble in property
prices precedes property price deflation.
The price of gold at $285 per ounce is not a deflation warning. By our
estimates, it would take a decline in the price of gold to $240 in order
to
indicate that zero inflation is likely. For example, a price of gold as
low as
$280 an ounce in 1985 did not produce a zero inflation rate in 1986. Actual
1986 consumer price inflation was 1.2% and the GDP deflator was 2.5%.
But the Fed should very carefully assess the risk of gold continuing to
a free
fall, as the price of gold incorporates global uncertainties as well as
a
possible warning of property price deflation.
Continued Worries
Mr. Greenspan and the FOMC have earned the trust that now enables them
to be patient with indications of increasingly tight labor markets. Inflation
only occurs when people lose trust in the guardianship role of their central
bank to maintain their money's constant purchasing power. That is why it
is
important for members of the FOMC to continue to worry out loud about
inflation. The decline in the price of gold well below $300 per ounce is
evidence that trust in the Fed is high.
The price of gold is a better indicator of the stance of monetary policy
than
is the rate of unemployment. Let the good times roll. And that requires
a
Federal Reserve dedicated to the pursuit of price-level stability.
Mr. Angell, chief economist at Bear Stearns & Co., is a former Fed
governor.