A critique of US Federal Reserve Board policy

It's too early to tell what course new U.S. Federal Reserve Board Chairman Ben Bernanke will follow, but the Fed staff still believes in the Phillips Curve – the idea that low unemployment causes inflation – says economist Brian S. Wesbury.

Economic growth and low unemployment do not cause inflation, and following models such as these has caused the Fed to make some huge mistakes. For example:

In June 1999, with the federal funds rate at 4.75 per cent, the economy was booming and the unemployment rate was 4.3 per cent.

The Fed ignored deflationary signals from falling commodity prices and hiked rates because it feared inflation.

By mid-2000, the federal funds rate was 6.5 per cent.

Inflation never appeared; instead there was both deflation and a recession. The Fed then cut interest rates a record-breaking 11 times in 2001, and eventually pushed them to 1 per cent – the lowest level in 50 years.

These cuts ended deflation, while tax cuts lifted growth, which continues to today:

First quarter 2006 real GDP growth in the U.S. looks to be above 5 per cent.

The unemployment rate is at 4.7 per cent (already below the Fed's year-end 2006 forecast).

The "core" inflation rate is above 2 per cent (the top end of the Fed's comfort zone), and capacity utilisation rates are at a six-year high.

But belief in the Phillips Curve encourages interest rate hikes, and the Fed has lifted rates at an unprecedented 14 consecutive meetings. One more rate hike and the Fed funds rate will be back at 4.75 percent – a perfect round trip from 1999.

The Fed's insistence on using capacity measures and the Phillips Curve causes it to overshoot on both sides – tightening too much and then easing excessively. The alternative is a market-based method of inflation targeting.

Source: Brian S. Wesbury (First Trust Portfolios L.P.), Life After Greenspan, Wall Street Journal, February 22, 2006.

For WSJ text (subscription required): http://online.wsj.com/article/SB114057637795579762.html?mod=opinion&ojcontent=otep

For more on Economic issues: http://www.ncpa.org/iss/eco/

FMF Policy Bulletin/ 07 March 2006