By raising its federal funds rate target early this month, the US' central bank indicated concern that rises in consumer prices could accelerate in the near future. As it is, the yearly rate of growth of the personal consumption price deflator rose by 3.27 percent in June.
In most pronouncements, the Fed indicates that further increases in the federal funds rate target are in the cards, but that it will be raised gradually. This open, gradual approach is generally thought to be useful, as it would allow individuals time to adjust to an impending tighter monetary stance.
This logic reflects a belief that transparency in policy making by central banks can minimize dis-ruptions so that it can steer an economy toward greater stability. A corollary of this thinking suggests that policy makers can apply various tools to engineer so-called soft landings. But there are reasons to believe that this sort of thinking is faulty. If so, it is likely that the Fed's attempts to tighten its monetary stance will eventually lead to much greater disruptions than is presently being forecast.
Contrary to popular fictions, neither the transparency of the Fed in its policy making nor its gradual approach in raising interest rates will prevent or weaken an inevitable economic bust. Indeed, the fact that a tighter monetary stance is required implies that factors that could cause an economic bust are already at play.
As it is, the severity of the downturn has already been largely predetermined by the long period in which the US central bank maintained a very loose monetary policy. This policy has undermined the pool of real funding and weakened the capacity of the US economy to correct itself quickly.
Since most Fed functionaries are monetarists, the views of Milton Friedman shape their thinking. Friedman points to variable lags between changes in money supply growth that determine the impact upon real output and prices. His view is that changing money supply growth can initially raise output with little impact on prices. But in the long-run, changes in money supply growth are neutral with respect to output and only impact on prices.
Robert Lucas, another Nobel laureate, suggests that money [supply] can generate a real effect in the short run, but he does not think it is related to the variability of monetary time lags. In his formulation, the link depends upon whether changes in central bank policy are anticipated or not.
According to Lucas, when monetary growth is anticipated, there will be quick adjustments that eliminate the effect on the real economy. Only when monetary expansions (or contractions) are unexpected can they can have a stimulative (or depressive) effect upon production.
For both economists, the ultimate impact of changes in the rate of growth of the money supply will be neutral with respect to the real economy. But their focus ignores the microeconomic effects of monetary policy. Monetary policy can never have a neutral effect on an economy because it disrupts the production structure and relative prices.
Another flaw in their analysis is more obvious. If unexpected changes in monetary policies can promote real economic growth, then policy makers can always orchestrate the creation of real wealth by simply printing more pieces of paper money. This flies in the face of practical reality that dictates that something cannot be created out of nothing. Introducing more pieces of paper money cannot change the underlying capacity of production or the basis of a surplus that allows an increase in savings. But higher growth in the money supply induces greater consumption even though no additional real wealth is created.
In this sense, pumping more money into an economy only diverts real savings from productive wealth-generating activities toward non-productive wealth-consuming activities. As such, this process undermines real economic growth by weakening the real pool of savings. This negative impact on the pool of savings does not depend upon individuals correctly anticipating changes in monetary policies.
As is evident now, central bankers must reverse their policies to avoid greater destabilizing effects from rising consumer prices and wages. But the long period of credit expansion has introduced massive distortions and prompted unwarranted speculative behavior that will extend the pain and the period of adjustment and recovery.
Several conclusions can be drawn here. The first is that expectations have little to do with whether loose monetary policy undermines the foundations of the real economy.
It is impossible to avoid the corrections that must take place to sort out the effects of loose monetary policies just because central bankers are transparent in their policy making.
Second, instead of promoting sustainable economic growth, economic booms created by artificially-lowered interest rates lead to busts that bring avoidable economic misery. Economic activities motivated by monetary pumping and credit expansion will wither under a tightened monetary stance and face an increased risk of having to be liquidated.
Since economic growth requires more real savings that can be used by entrepreneurs to spend on capital goods and new technology, softening the impact of a bust requires an expansion in the pool of real savings. But this seems unlikely, since the current debt levels in the US economy are quite high, indicating that the pool of real savings is either stagnant or declining.
Christopher Lingle is visiting professor of economics at Universidad Francisco Marroque in Guatemala and Global Strategist for eConoLytics.
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