The Fed Must Strengthen the Dollar

By John L. Chapman
Tuesday, April 29, 2008

When Federal Reserve governors meet today, they should consider that solutions to their twin challenges – a flagging economy and systemic moral hazard in financial markets – have common roots in a stable dollar. One of the primordial lessons of economic history is that sound money is a necessary condition to promote long-run prosperity and maximal growth. Moreover, a stable currency and low inflation lessen the need for complex hedging vehicles which can be leveraged to harmful effect in volatile markets.

Unfortunately, with total first quarter job losses up to 232,000 and the University of Michigan Consumer Sentiment Survey at its lowest level since 1982, fed funds futures indicate a strong likelihood of a cut of 25 basis points in the fed funds rate. But will yet more interest rate cuts help the economy or lower the problem of moral hazard?

To understand why it may not, and why a different path should be taken, it must be recognized that Fed policy has long been guided by – or perhaps more accurately, yoked to – the alleged trade-off between unemployment and inflation: the so-called Phillips Curve.

A.W. Phillips's original 1958 paper dealt with wage rate changes and unemployment. But eventually it would become conventional policy wisdom to apply his insight more broadly to price level movements against the unemployment rate.

Over time, the Phillips Curve became conventional macroeconomic wisdom and an extension of Keynesian fine-tuning, i.e., a menu of choices along with a rationale for discretionary monetary policy to effect changes in employment levels.

Phillips's work is important and has been validated over short time frames when inflation and unemployment are low. But Milton Friedman and Edmund Phelps showed that the relationship broke down in the long run, due to expectations and changing institutions and technologies. Over a long horizon, employment and growth are a function of real factors; inflation and unemployment often move in tandem, not as a trade-off.

Since 1948, according to Bureau of Labor Statistics figures, inflation has averaged 3.7% per year, unemployment 5.6%, and real GDP growth 3.4%. But the 10 lowest inflation years (between 1949-62, and 1986) averaged 0.5% inflation and 5.2% unemployment, along with 3.5% GDP growth. And the 10 high inflation years (between 1973-81, 1969, and 1990) averaged 9.1% in consumer price increases, along with 6.2% unemployment and 2.6% in growth. In other words, low inflation was often associated with lower unemployment and stronger GDP growth than high-inflation years.

More strikingly, the years following the 10 lowest inflation years were even better in terms of performance (averaging 5.1% unemployment and 4.4% growth), and the years following the high inflation years were even worse (7% unemployment and 1.4% GDP growth). This record shows the importance of sound money, fostering an environment allowing the key growth drivers of entrepreneurship and capital investment to flourish under stable long-run expectations.

Why would the Fed base policy on a trade-off which does not hold beyond the short run, and is the underlying premise of the stop-go monetary strategies that have caused boom-and-bust instability? Partly because the Phillips Curve framework is so universally and deeply ingrained. Partly because until recently the Fed has held that inflation is not a threat, and that the economy now demands low short-term rates and unlimited liquidity.

In spite of Fed indifference, however, inflation warnings are ubiquitous. Commodity and consumer prices are soaring, and the dollar continues to weaken against the euro and other currencies. Broad measures of the money supply are expanding rapidly. One such measure, MZM ("Money of Zero Maturity"), has grown 16.3% in the last year, accelerating to a 30.3% annualized rate since the middle of January. MZM – equivalent to M2 minus time deposits, plus all money market funds – measures money or assets that can be quickly turned into money at par. Thus it captures the real level of liquidity and spending power in the financial system. Rapid growth in liquidity guarantees inflationary pressures.

Also, the U.S. dollar is the de facto international reserve currency; as the demand for dollar-denominated assets such as U.S. Treasurys bids up their price, the interest rate the Treasury has to pay to borrow declines. Without that demand, interest rates would rise and, with domestic savings diverted to service the debt, output would be lower and prices higher.

But exploding fiscal deficits, the housing correction, protectionist threats and $200 billion in tax hikes scheduled for 2011 are fueling loss of confidence in the U.S. dollar. If foreign holders of dollars or dollar-denominated assets sell them, all the good effects of being the de facto international reserve currency start operating in reverse. Until fiscal and monetary policies change, all this implies future inflation and higher interest rates.

The bottom line is this: the Fed should bury its errant Phillips Curve framework, and cease attempts to fine-tune perfect balance between inflation and recession. It should halt further rate cuts and soon begin a series of interest rate increases.

As for the risk of further credit-market blow-ups, the Fed's new lending facilities and the discount window are more appropriate tools for case-by-case illiquidity issues than blunt interest-rate mechanisms.

Neither current market imbalances nor the longer-term threat posed by moral hazard can be eradicated easily. And the considerable fiscal challenges facing the U.S. economy are not the responsibility of the central bank. But inflation and an unstable dollar are mortal enemies of prosperity. With inflation, millions are burdened by cost-of-living increases, real profit contraction, capital decumulation, and an inability to easily make contracts, calculate entrepreneurially, or invest.

By discarding the Phillips Curve blinders, the Fed would happily learn that economic growth and low inflation are not a mutually exclusive trade-off. A stable dollar promotes both, along with making fiscal and moral hazard problems easier to solve in the future.