Sorry Hopeful Pundits, the Fed Cannot Control Inflation
The Fed believes economic growth is the source of inflation. Hard as it may be for most readers to believe the latter, the broad view inside the Fed is that too many people working and prospering will cause the economy to "overheat." Fearful of too much prosperity, the central bank explains that it must centrally plan economic growth that's weaker than would otherwise be the case in a free market. More explicitly, the Fed's policy - assuming a booming economy - is to put people out of work.
If readers doubt any of what's just been written, they need only consider a recent op-ed by a once highly-placed Federal Reserve official:
"If the Fed waits until the natural rate of unemployment is reached, there will be many months when interest rates are too low. These low rates can cause the economy to overheat, putting pressure on prices."
The Fed cannot control inflation simply because as the above passage reveals, what the Fed presumes inflation to be quite simply is not. Economic growth, no matter how abundant, is never the source of broad pricing pressure. In truth, economic growth is, almost by its very description, evidence of falling prices.
But first it makes sense to address Fed thinking that presumes the U.S. is an island with no access to non-U.S. labor and production capacity. That's why the Fed thinks growth causes pricing pressure; that we'll basically run out of labor and production capacity. Yet as the halfway sentient no doubt realize, U.S. companies regularly access abundant labor and manufacturing capacity well outside the U.S. Lou Dobbs calls it "outsourcing."
After that, U.S. companies are constantly figuring out ways to attain more output with less in the way of labor inputs. This is called productivity. We live it all the time. As readers of this column know well, it's rare that this writer deals with a live human being at the bank, grocery store and gas station, not to mention while buying movie, airplane, or train tickets. Markets constantly innovate around the limits to labor imagined inside a Federal Reserve plainly untouched by the real world.
Indeed, were the Federal Reserve more aware of what's happening out there it would know that economic growth is almost tautologically evidence of price-shrinking advances in productivity. Getting more from less in the way of labor. During the early part of the 20th century as the global economy soared, the price of a car plummeted. In the 1980s and ‘90s as the economy similarly soared, the price of increasingly advanced computers fell. With the proliferation of the internet, the prices of most everything fell. Forbes publisher Rich Karlgaard long ago tagged all this frenzied economic growth gifting us with falling prices as the "Cheap Revolution."
When you think about it, economic growth is always a "Cheap Revolution" when we remember it was spurts of growth that turned former luxury items like the car, mobile phone, computer and internet into common goods enjoyed by all. More to the point when we consider again what Fed economists deem "inflation," the car, cellphone, computer and internet are among the biggest job destroyers in world history. To put it as plainly as possible, the very prosperity that the Fed seeks to blunt is what erases the very labor "shortages" the Fed naively deems inflationary in the first place. While the Fed is wholly confused about the nature of inflation, missed by Fed officials is that the abundant growth it's incorrectly afraid of as the source of inflation is in fact its cure.
Of course, some Fed apologists will reply that in fiddling with interest rates the Fed is pursuing a monetary objective whereby it limits the amount of credit on offer in the economy. The problem with such theorizing is that the banks the Fed interacts with represent but 15-20% of total lending. Most lending occurs outside the banking system as is, so if the Fed "tightens" as it were, other non-bank sources of credit ably make up for it with their own lending.
All that, plus let's not forget that we're operating in what is a global economy. Assuming the Fed actually succeeds in shrinking the amount of credit on offer from banks, the only closed economy is the world economy. If the Fed drains the U.S. pond of credit, other non-Fed sources of credit from around the world will fill in. An interest rate, even an artificial one set by the Fed, is a price. If Fed efforts to "tighten" actually lead to a higher cost of credit, the price signal itself will serve as a lure for new sources of credit inside and well outside the U.S.
And then some monetary theorists, monetarists most notably, think the Fed can fight inflation by "shrinking the money supply" through rate and open market operations. Nice try. The Fed quite simply cannot control money supply. It can't because production itself is money demand. Money is what we use to facilitate exchange of the actual wealth we create,it represents access to the economy's actual wealth, and that's why producers of lots of wealth have lots of money. Money follows the production. Unless the Fed is centrally planning who produces, and where they do, the Fed is not nor can it control money supply.
To understand how little the Fed controls money supply, think about the above in terms of Silicon Valley. Lots of wealth is created there, so imagine if the Fed, naively worried about inflationary pressures in the Valley, were to shrink money supply in Palo Alto in hopes of boosting same in East Palo Alto, its notoriously poor neighbor. If so, the money supply shifted to East Palo Alto by the Fed's planners would almost instantaneously migrate back to Palo Alto. It would because money once again follows production. The Fed can attempt to stimulate sagging economies while neutering booming ones all it wants, but money and credit invariably seek the most productive concepts; thus revealing Fed attempts to control "excess" supply of money it deems inflationary as utterly worthless.
Ultimately the only true inflation is a decline in the value of the currency; in our case a decline in the value of the dollar. Missed by those obsessed with the Fed is that the dollar's exchange value is the U.S. Treasury's responsibility. Still, the Fed couldn't target or fight inflation in the first place simply because what the Fed sees as inflationary (too much growth, too much credit, or too much "money supply") has nothing to do with inflation.
