Stories At The Margin
columnist: Christopher Espinal

Topic: Economics
More Inflation not the Answer

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The Role of Rational Expectations and why Bernanke should halt further movement.

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by Christopher Espinal
(Conservative)
Tuesday, March 18, 2008

Recently, the former President of the Cleveland Fed, Lee Hoskins, didn't have nice things to say about the Federal Reserve's actions towards the potential market crisis. "The Fed needs to quit chasing declining GDP growth and instead focus on curbing inflation and anchoring inflation expectations," are the words of the former local Fed Chief.

Bernanke and his crew in Washington have all decided to cut the Federal Funds Rate by 50 basis points amid fears of a recession. Policies aimed at impacting Aggregate Demand falls at the center of a serious debate between economists. According to Rational Expectations theory if the market expects continued drops in the target interest rate, companies will only make projections on their budgets against greater rates of inflation. Thus, the Fed will fail at its attempts to push out Aggregate Demand in a concerted effort to stave off falls in output.

Others would say, including Edmund Phelps, sure we can notice patterns of market activity and use that information for future expectations, but we can never really make good projections of the future because of incomplete information.

However, Milton Friedman would be the first to point to the Greenspan era, where the former Fed Chairmen sought to control inflation, which led to grand improvements in the economy. Not only did Americans enjoy rising real GDP but they also experienced greater wealth with falls in the Price Level because of accurate expectations of inflation by the market. The market was able to efficiently allocate it's capital without confusions caused by inflation. Most economists agree that this fine economic period was the result of responsible inflation targeting policies on behalf of Mr. Greenspan.

It was quite fortunate to hear monetarist Ben Bernanke's interest in continuing inflation targeting policies. He and every other member of his school of thought know that the market responded quite well to price stability and the lack of confusion with market pricing.

But let's take a step back here: has Bernanke's gang hopped onto a different bandwagon during this series of worrying economic events? Let's take a look at the record:

September 18 was when the Federal Reserve began deciding on cuts in the Fed Funds rate. The market is expecting another drop in interest rates today. That means the Fed managed to cut interest rates by 2 whole percentage points in a matter of months. The printing machines are getting red hot and probably for no reason. Economists are now wondering whether these known expectations in rate cuts will help stimulate the economy or just lead to higher rates of inflation.

This is another issue of which economists tend to disagree because some believe that there is a tradeoff between inflation and unemployment, also known as the Phillips Curve. In other words higher rates of inflation can lead to low rates unemployment. Once again, rational expectations are here to slash the belief that inflation will help unemployment. Companies won't be fooled into believing that they are wealthier; they will only believe that they are accumulating more greenbacks - monetary neutrality at its best. The Phillips Curve will only be pushed out as opposed to improve unemployment. We should only expect higher rates of inflation and unfortunate market-wide misallocation of capital and labor. Guess what that will lead to?

Stagflation! As Hoskins and Murphy rightly point out the CPI and PPI have risen by 4.0% (BLS, par1) and 7.4% (BLS, pp2) respectively, while real GDP slowed to 0.6% for the last quarter. It is important to note that the 0.6% has been revised to 1.6%, which makes me skeptical of their assessments, but the drop is probably still worth taking into account. If the trajectory of the economy is actually recessionary with Short Run Aggregate Supply pushing backwards then this recession could be disastrous. Falling output and rising prices signals an up and coming period of stagflation that is far greater a threat to our short run comfort than anything else.

Now back to Bernanke. He can make the situation less household and market friendly by continuously trying to push out Aggregate Demand through inflationary monetary policy. Printing more money doesn't make workers and businesses more productive but more confused and anxious about their money situation.

I'm not surprised that many economists are becoming weary of the Fed's recent monetary policies. Just several days ago the Fed granted J. P. Morgan Chase tens of billions of dollars to help purchase the company that fell on its knees - Bear Stearns. The last time the Fed took measures with helping the financial markets was during the Great Depression. It's a serious question to ask whether or not they made a smart choice. We don't want financial institutions to believe that they are insured by the federal government because moral hazard can spread and be disastrous in a situation that seems quite difficult.

Depressed markets tend to weed out companies that shouldn't be in place and that's simply the way the market works - sorry Bear Stearns. We all take risks when we leave our homes or when we take a stroll at night. Companies take risks, silly ones in this case, when investing money and wealth into folks who can't manage their own budgets.

Please oh please Bernanke. Make our situation easier by not continuing inflationary policies when people are expecting higher rates of inflation. It does nothing more than confuse us!

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2008 Christopher Espinal, all rights reserved.
Published: Tuesday, March 18, 2008
Last modified: Friday, March 28, 2008

The views expressed in this article are those of Christopher Espinal only and do not represent the views of Nolan Chart, LLC or its affiliates. Christopher Espinal is solely responsible for the contents of this article and is not an employee or otherwise affiliated with Nolan Chart, LLC in his/her role as a columnist.

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