Ease up on the Gas Pedal, Bernanke!

Why is this happening? The answer is painfully clear. From the end of January 2008 to the end of January 2009, the Federal Reserve's monetary liabilities, the sum of currency and bank reserves known as the "monetary base," more than doubled. This is a year-over-year expansion unprecedented in the Fed's history. During the last three months of that period alone, the base grew an incredible 50%. (At that pace, it would have quintupled in a year's time.) The base has thankfully receded a bit in February.

Broader measures of the money stock reflect the rapid growth in the base. The M1 measure (the sum of the public's currency and checking deposits) has grown at an annualized rate of 23% over the last six months, while the broader M2 measure has grown at 15%. As standard theory predicts, this rapid money growth has pushed short-term interest rates to historic lows. For the last 10 weeks 12-month Treasury bills have been trading at yields below 0.6%.

For perspective, flash back to the early years of the Great Depression. Between 1929 and 1932, runs on the banking system led to a sharp decline in the money stock, leading in turn to a general deflation. The best-known historians of the event, Milton Friedman and Anna J. Schwartz, faulted the Federal Reserve system for not using its money-creation powers to stop the decline.

In a 2002 speech at a conference honoring Milton Friedman on his 90th birthday, Ben Bernanke promised that the Fed would never again commit that error. Today, as chairman of the Fed, Bernanke is so eager to fulfill his promise that he is erring strongly on the side of monetary overexpansion.

Chairman Bernanke is quite right to want to avoid a collapse of the money stock, because when that happens, economic activity contracts needlessly. Certainly the Fed should not sit idly by while the money stock shrinks.

But today's money stock is not collapsing--not by a long shot. Moreover, while asset prices have fallen over the past year due to the bursting of real estate and stock market bubbles inflated by years of excessive money growth, the prices of consumer goods and services have not. The decline of asset prices thus does not represent a general deflation. Instead, it represents the correction of a relative price distortion. The reduction in asset prices is actually the beginning of recovery; thus, an effort to prop up asset prices delays recovery.

Asset prices rose more quickly than the prices of goods and services during the money-fueled expansion, because interest rates were artificially low. It is impossible to keep interest rates artificially low forever, so the relative price of those assets was set to return to normalcy in one of two ways: either by a fall in asset prices or by an increase in the prices of goods and services.

Chairman Bernanke's strategy is seemingly staving off a further decline in nominal asset prices by expanding the money stock. Equilibrium will have to be re-established in the only other way possible--through a general inflation of consumer prices.

Despite the dramatic reversal in real estate prices, and the Dow Jones industrial average of stock prices having lost 40% of its nominal value from the high point of the past 12 months, the sky has not fallen. The real output of goods and services in the fourth quarter of 2008 (according to the revised estimates of the Bureau of Economic Analysis released last week) was less than 1% below the level of Q4 2007, having grown modestly over the first half of 2008 and declined modestly over the second half.

Consumer prices are not plummeting. Despite several months of slight declines during the second half of the year, the 2008 average Consumer Price Index was up 3.8% from the previous year. The December 2008 CPI was up 0.1% over December 2007. As previously noted, January 2009 is up over December 2008.

The fact that consumer prices are not yet rising as fast as the stock of money is growing indicates that the "velocity" of money, or the annual consumer spending per dollar of money balances held, has temporarily declined. The huge additions to the monetary aggregates are currently being mostly absorbed into "idle" cash balances, but like a sponge, cash balances will only absorb so much.

With continued Fed expansion, money balances will exceed the amounts people want to hold. Velocity will begin returning to normal. As spending begins to catch up with money growth, the Fed will face a difficult choice: either slam on the money brakes and risk having the recovery stall out, or continue its current pedal-to-the-metal policy and cause accelerating inflation.

This is not a new situation. In 1973 to '75, the U.S. had a deep recession. Rather than let the effects of the Arab oil embargo run its course, the Fed attempted to soften the blow with expansionary monetary policy. Though there was little inflation to start, it took off as the economy began expanding and velocity began to rise. Inflation as measured by the CPI grew from 5.8% to 6.5% to 7.6% to 11.3% to 13.5% between 1976 and 1980. Extricating the economy from the distortions built up during that long period of monetary expansion required the sharp Reagan-Volcker recession of 1981 to 1983.

Then Fed Chairman Greenspan warned that the stock market was exhibiting "irrational exuberance" in 1996, even as he oversaw a rapid increase in the money stock. He took comfort in the fact that although asset prices were rising rapidly, there was little inflation as measured by the CPI. He overlooked the effects monetary expansion was having on asset prices. Greenspan should have worried more about asset prices then, and Bernanke should worry less about them now.

A fall in inflated asset prices does not a general deflation make. It is, in fact, the first step on the road to recovery. The sooner asset prices find their bottom, the sooner they can begin to rebound--and that is the key to restoring investor confidence.