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The Fed has now moved to its most inflationary policy stance since the late 1970s. China, which pegs its currency to the dollar, and therefore accepts Chairman Greenspan as its central banker, has seen a complete reversal of fortunes. It experienced painful deflation between 1999 and 2002, and is now experiencing enough inflation to compel dramatic credit tightening by the central government.
THIS VOLATILITY IN MONETARY policy is damaging to any economy. More to the point, it is unnecessary. The main reason for these sharp swings in interest rates is that the Fed seems to follow what the Wall Street Journal dubs “The Greenspan Standard.” This standard seems to flow from the forecasts of the chairman himself.
Looking back at the arguments used by the Fed to justify its policy shifts, there is no consistent framework. In the late 1990s, the Fed argued that “insecure workers” were holding back wage growth and therefore the true inflationary impulse of the economy was hidden. During that same period of time, Greenspan was supposedly an early convert to the idea that productivity growth had accelerated, and inflation would remain subdued. These arguments, however, were contradictory.
But then in February 2000 Greenspan took an unexpected turn. He argued that strong productivity growth actually caused higher inflation. His theory went like this: Strong productivity growth boosted estimates of corporate profits and pushed up the stock market. A rising stock market caused a wealth-induced boom in consumer spending that exceeded supply. With aggregate demand growing faster than aggregate supply, inflationary pressures would increase.
The only problem with this “productivity causes inflation” argument is that there is absolutely no economic theory to back it up. In fact, the Fed found no support whatsoever for this argument from the economic community at large and never repeated the argument again. However, this did not stop the Fed from increasing interest rates anyway.
IN RETROSPECT, IT APPEARS THAT Chairman Greenspan was making up new economic arguments to justify the actions that he had already decided were appropriate. This is why it is easy to call it “The Greenspan Standard.”
There are at least two problems with this state of affairs. First, because Greenspan alone understands this standard, whoever replaces him will by definition have a different standard. Second, there is no legacy for managing Fed policy. These are both destabilizing issues. If, when a new chairman is appointed, the Fed changes along with that appointment, there is no guarantee that policy will remain consistent.
To avoid volatility in monetary policy, the Fed should institute a price rule for monetary policy and target inflation rather than unemployment, GDP growth, or stock prices. The best way to do this is to follow sensitive market prices such as the dollar, commodity prices, and gold. These markets react to monetary policy well before consumer price inflation and do not suffer the same measurement problems as lagging economic indicators, such as the labor market or capacity utilization.
As the president begins to think about who might replace Greenspan in 2006, continuity and stability in policy should be the number one issue. And the only way to guarantee this stability over time is for the president to appoint someone who believes in a price rule for money and does not count on a cult of personality to defend the institution. Steve Forbes, Larry Kudlow, and David Malpass would all fit the bill. There are less than two years to lay the groundwork. It is time to start now.
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