Bernanke Has a Volcker Moment

Last Friday's employment report showing month-over-month non-farm payrolls increasing a mere 18,000 (compared to the consensus estimate of 70,000) indicated to the markets that economic growth is weakening and that profit growth is at risk. The unemployment rate now stands at 5.0%, versus 4.7% in November.

Just as the growth outlook deteriorates, inflationary pressures are worsening as evidenced by the weak dollar, which has revealed itself through record oil and gold prices. Confirming these forward-looking indicators, November’s year-over-year CPI jumped to 3.5 from 2.8% in October. With weakening economic growth and rising inflation, monetary policymakers at the Federal Reserve are stuck in a false dilemma: cut rates to help support economic growth or raise rates in an attempt to support the dollar and ward off inflation.

Most economists who view gold as a forward-looking inflation signal are calling on the Fed to keep rates higher than the markets desire today, or, would like the Fed to raise them under the supposition that rate increases equal monetary tightness. But this thinking ignores how interest-rate targeting works.

The real purpose of funds rate policy is for the Fed to change the level of interest rates in order to affect spending and economic output, and thus inflation. In Fed-speak, this is called the monetary policy "transmission mechanism” by which the Fed seeks to control the economy and inflation. The institutional theory of demand-siders at the Fed posits that slowing growth translates into lower prices (disinflation), while accelerating growth leads to inflation. Supply-side thinking rejects this theory and believes accelerating growth is actually disinflationary and vice-versa.

But the more important point is that fed funds rate policy is designed to control economic growth, NOT a method for controlling the rate of money supply growth or stabilizing the gold price. It is therefore a popular and unfortunate misconception that higher interest rates translate into tighter money.

In other words, advocates of higher interest rates today are in essence supporting a policy that aims to weaken economic growth even further; growth that is already sagging as evidenced by last Friday's unemployment report. Sadly, actions taken to reduce economic growth will ultimately do little to reduce true inflation, nor will they restrain forward-looking inflation indicators.

The Fed experienced a comparable dilemma to today's during the late 1970's; albeit to a more extreme degree. At the time, the Fed similarly manipulated short-term interest rates with little success in preventing a painful stagflation. Failed rate-targeting efforts eventually forced Fed Chairman Volcker to abandon interest rate targets in favor of monetary aggregate targets in October of 1979.

The policy change was an explicit acknowledgment by the Fed of the failures inherent in targeting the cost of credit to control growth and inflation; especially when growth is slowing and inflation is rising. Volcker was surely courageous in reversing what was a failed policy, but his policy alternative was not perfect because it singularly attempted to directly control the expansion of the money supply to fight inflation. We must remember that monetary inflation is always the condition of too much money relative to money demand. Monetarist targets then and now concentrate solely on money supply without factoring in demand for same.

Fortunately, by 1981, President Reagan’s combination of strong defense policies and low tax rates encouraged production and entrepreneurial risk-taking, all of which worked together to increase the demand for dollars. The latter combination, whereby Volcker watched money supply growth and Reagan policies increased money demand, worked powerfully to reduce the excessive dollar supply-demand imbalance, which reduced inflation, pulled commodity prices lower and strengthened the foreign exchange value of the dollar. The dilemma over slow growth and high inflation was corrected and each man will be favored by history.

Fast forward to today, Ben Bernanke has the chance to seize this monetary moment before being confronted with the harsher extremes Volcker once faced. Rather than continuing to guess about the proper level of interest rates, Bernanke should do as Volcker once did and reject the Fed's targeting mechanism.

He should do so while setting a gold price target; the latter's stability a signal that dollar demand is matched by supply. These actions would stabilize the value of the dollar, immediately ameliorate the inflation environment, restore reliability to the dollar as an internationally recognized unit of account, and establish a sound monetary standard free of the distortions that promote inflationary cycles, including the one that threatens the economy as this is written.