GMO's Jeremy Grantham, surely one of the finest investment strategists of our time, is no fan of the Federal Reserve's track record over the past decade or so. In fact, he's gone on record with sharp criticisms of the central bank. This is an institution, after all, that's made mistakes, to say the least. But how to proceed? In his latest quarterly missive, Grantham remains skeptical that the Fed has a silver bullet solution up its sleeve for the various problems that ail the economy at the moment. He did, however, suggest in so many words that Bernanke and company should adopt an inflation target. A reasonable idea, but one that comes with some assumptions on the mechanics--assumptions that complicate the analysis at the moment on what the Fed should, and shouldn't do, for those of a particular world view.
To be precise, Grantham advises that "if I were a benevolent dictator, I would strip the Fed of its obligation to worry about the economy and ask it to limit its meddling to attempting to manage inflation." But here's the problem: After reading the remaining 15 pages of Grantham's analysis and commentary (along with his long-running views from the past), it's easy to come away with the idea that he's no fan of another round quantitative easing (QE2), a.k.a. a new effort to buy up Treasuries in order to lower medium- and long-term interest rates. But if the Fed is expected to target inflation, isn't the case for QE2 compelling these days? Perhaps. But arguing in favor of QE2—an activist role for the Fed—is an awkward position for Grantham, and many other strategists.
But the numbers, if we accept them at face value, suggest that QE2 may be required. Inflation, after all, is falling. Last month, the annual pace of headline consumer inflation has been falling steadily this year, and other measures of inflation have been following suit. Letting it continue to fall risks making a huge mistake, perhaps on par with the Fed's ignominous record in the 1930s.
The argument, then, that the Fed should work to stop inflation from dropping further looks persuasive, at least if you believe that inflation should be relatively stable and contained over time. That means that if inflation is falling, and it's falling at unusually low levels at a time when the outlook for economic growth is weak, the argument for quantitative easing to reflate is stronger.
Suddenly, however, it's not clear we're going to get QE2 after all, or perhaps not enough to make a difference. "Doubts about the wisdom and efficacy of the policy among economists and some of the Fed's own decision makers," The Wall Street Journal reports, have recently raised questions about what to expect at the Fed's FOMC meeting next week.
The renewed debate about what's coming has boosted the dollar, at least temporarily interrupting its decline of late. But that's not necessarily good news for the near term if—if—inflation is set to continue falling. A rising dollar and falling inflation is a problem, even if it's not obvious when focusing on each side of this equation separately. For some of the details, read David Wessel's article today in the Journal, which argues that the-late Milton Friedman would have argued in favor of QE2, a point I made last week.
The question, of course, is whether inflation really is going to continue declining. As always, the future's debtable. But yesterday's news that capital spending fell last month is a sign that there's still plenty of doubts about the economic trend to keep worries alive for now. Add to the mix the questions about how effective QE2 can be, if at all, and we have the foundation for a potent debate.
But this much is clear: arguing on behalf of stabilizing inflation makes for strange bedfellows these days. So it goes as the Great Experiment in righting economy rolls on.
This post has been republished from James Picerno's blog, The Capital Spectator.
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