The Specter of Stagflation

For the past six months, the Fed has been under enormous pressure to ease money and credit. It has. The overnight Fed funds rate has fallen from 5.25 percent in early September to 3 percent at the end of January. Politicians are clamoring for the Fed to prevent a recession and cushion the effects of the housing collapse. Banks, investment banks and other financial institutions want cheaper credit to enable them to offset losses on subprime mortgages. There is fear of a wider economic crisis if large losses erode confidence and, by depleting the capital of banks and other financial institutions, undermine their ability and willingness to lend and invest.

Unfortunately, the Fed shows signs of overreacting to these pressures and repeating the great blunder of the 1970s. Underestimating inflation then, the Fed repeatedly shoved out too much money and credit in a vain effort to keep the economy near "full employment." Inflationary psychology became widespread, and the resulting wage-price spiral fed on itself. Now, switch to the present. Again, the Fed has underestimated inflation. It expected the economic slowdown to suppress inflation spontaneously. This belief helped rationalize the dramatic easing of credit through the five rate cuts since mid-September. But so far, the lower inflation hasn't materialized in part because, outside of housing, there hasn't been much of an economic slowdown.

It's true that the Fed is treading the proverbial tight rope. No one wants a financial crisis; but no one should want the return of stagflation either. The trick is to provide enough credit to prevent the former and not so much as to cause the later. In judging what that balance should be, the Fed needs to be less intimidated by present problems and more concerned with long-term consequences. The American economy—a marvelous but flawed engine of wealth—periodically goes to speculative or inflationary excesses. If most of those excesses aren't given the time to self-correct, we may be trading modest pain today for much greater pain tomorrow. Trying to prevent a recession at all costs is a fool's errand that could ultimately backfire on us all.

© 2008