The stock market isn't a happy camper. Yesterday's 3% drop in the S&P 500 was a sign that the deflationary worries that revived in May are still considered a real and present danger, including the possibility that the disease may affect the mother of all headline pricing series: GDP. No wonder that with a renewed worry over the D risk, government bonds are hot once more, with rising demand pushing the yield on the benchmark 10-year Note under 3% yesterday for the first time since April 2009.
Much of the discussion is now focused on whether talk of fiscal austerity is to blame for new surge in risk aversion. It's premature to emphasize budget cutting when the economic rebound is tenuous and the labor market has yet to show convincing sounds of durable and sustained growth. This argument can't be dismissed, but the more immediate threat seems to reside in monetary policy.
The annual pace of change has fallen sharply recently for various measures of the money stock in the U.S., from M1 to M2 and MZM. Seasonally adjusted M1, for instance, rose by 3.0% over the past year, based on weekly data through June 14. That's down from nearly 20% a year ago. MZM money supply has suffered an even sharper retreat and was is now in negative territory to the tune of -2.4% vs. the year-earlier reading midway through this month, as the chart below shows.
Is the money supply retreat relevant? Yes, or so a fair reading of economic history strongly suggests. Indeed, it's now been half a century since the publication of Milton Friedman and Anna Schwartz's monumental work A Monetary History of the United States, 1867-1960, which reordered the notion of cause and effect in analyzing the business cycle generally and the Great Depression in particular. The crucial factor is the evidence that the U.S. money stock fell by one-third during 1929-1933—at a time when it should have been rising, or at least holding steady, to offset the deflationary forces ravaging the economy. Summarizing the central bank's colossal error in the 1930s in Capitalism and Freedom, Friedman wrote:
Had the money stock been kept from declining, as it clearly could and should have been, the contraction [in the early 1930s] would have been both shorter and far milder. It might still have been relatively severe by historical standards. But it is literally inconceivable that money income could have declined by over one-half and prices by over one-third in the course of four years if there had been no decline in the stock of money. I know of no severe depression in any country or any time that was not accompanied by a sharp decline in the stock of money and equally of no sharp decline in the stock of money that was not accompanied by a severe depression.The current Fed chairman Ben Bernanke knows this, of course. As one of the leading authorities on the monetary history of the Great Depression, Bernanke is ideally suited to fight the D risk in the here and now. And to be fair, Bernanke has applied some of those lessons, albeit in fits and starts, in recent monetary policy decisions. Today's economic threat generally is still a fraction of what it was in the early 1930s, and that's largely because macroeconomic wisdom has progressed in some respects. We've learned a lot over the decades, despite what you read. Even Friedman's great insights are just the tip of the iceberg by current standards.
The fact that the target Fed funds rate has been virtually zero for almost 2 years is one sign that the Fed has made at least a partial effort to atone for the institutional sins of the thirties. But as economists like Scott Sumner have been arguing persuasively for some time, monetary policy can and should do more (see here, for instance). In other words, the fact that nominal Fed funds is just about nil isn't necessarily a sign that the central bank is doing all it can to battle the risk of deflation.
Until May, the case that the Fed should do anything more was muted, thanks to the rebound in the appetite for risk. But now there's reason to wonder if Bernanke and company are misreading the economic tea leaves with a misguided monetary policy--a mistake that isn't obvious by looking at the nominal Fed funds rate alone. One recommendation is that the Fed should target a higher inflation target. Yet Bernanke has gone on the record saying that he rejected such a course. In a Wall Street Journal Q&A last December with various bloggers and economists, Brad Delong asked Bernanke: Why haven’t you adopted a [higher] 3% per year inflation target? The Fed head's response:
The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.In short, Bernanke's worried about inflation, or at least he was in December. Is he still worried? It seems so, based on the rapid fall in the annual pace of change in the money stock. To be sure, worrying about inflation isn't a trivial concern, given the inflationary bias of fiat money. It'd be foolish to stop worrying inflation as a general principle. But inflation isn't a pressing concern at the moment, as we discussed yesterday. Yes, inflation will eventually become a concern, and perhaps a big concern, and sooner than the crowd expects, given the mounting debt on the government's balance sheet. And so we need to be ever vigiliant. But that's not the burning issue today, and it probably won't be for the near-term future. Deflation, by contrast, is a real and present danger. It may be a false danger, but it'd be unwise to ignore it at this point, given all the various warning signs bubbling elsewhere in the economy.
The Fed must fight the enemy at its door, rather than focus on the enemy that may attack in the future. And, yes, at some point, the focus will shift from deflation to inflation, at which point the central bank must act aggressively to mop up the excess liquidity. As always, there's a danger that the Fed may mishandle that priority when it arrives. Meantime, it seems to be mishandling the danger du jour.
Is deflation really the priority today? This is economics, and so there's always doubt. The good news is that monetary policy can be adjusted rapidly, in contrast to fiscal policy, which suffers from a number of setbacks that at this point make it look materially less desirable. The idea of waiting for Congress to debate the merits of a new fiscal stimulus, for starters, runs the risk of doing nothing for several months while the economic risk festers. And then there's the debate about fiscal vs. monetary stimulus generally. But we'll leave that topic for later. For now, cranking up the printing presses is practical and compelling today.
Why isn't Bernanke's Fed doing so? Perhaps there's political pressure, or perhaps he has information that suggests deflation isn't the risk that it appears to be. But the clock is ticking and the stakes are rising. If the money stock's rate of change keeps falling, the D risk looks set to rise.
This post has been republished from James Picerno's blog, The Capital Spectator.