Oversteering

This article appeared in Forbes on December 11, 2006.
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Central bankers rarely admit mistakes unlessthey are discussing events long lost in the fog of history.That's what makes the Nov. 2 remarks byRichard Fisher, president of the Federal ReserveBank of Dallas, so remarkable. Fisher candidly tolda gathering of the New York Association for Business Economicsthat an inflation gauge relied on by the Fed (the index forcore personal consumption expenditures) was malfunctioningfour years ago.

Back in those days the annual increase in the core PCE wasdrifting below 1%, signaling an approaching deflation. Thismoved then Fed governor Ben S. Bernanke (now chairman) todeliver a dense and noteworthy speech, "Deflation: Making Sure'It' Doesn't Happen Here," on Nov. 21, 2002. The most memorableline: a semiserious reference to the possibility that the Fed,in a real pinch, could increase the money supply by droppingbills from helicopters.

The Fed did not, in any event, employ aircraft in its openmarketoperations. But it did manage to work the Fed fundsrate down to 1%, providing considerable fuel to the inflation incommodity and home prices over the past four years. Fisherconcluded that this looseness in the money supply was a mistakeand that it was caused by faulty statistics. The Fed's favoritemeasure was underreporting inflation.

If nothing else, Fisher's diagnosis of the recent past is yetanother good reason to dust off the works of economists fromthe Austrian School, particularly Friedrich Hayek's. The mainlesson from the Austrians was their extreme skepticism aboutthe exclusive reliance on one magic index—the price level—toguide central bank policy. Indeed, Hayek stressed that changesin general price indexes don't contain much useful information.He demonstrated that it was the divergent movements of differentmarket prices during the business cycle that counted. Evena casual review of prices for different commodities, goods andservices, as well as assets and the value of the dollar, would haveenabled the Fed to avoid its mistake. This, of course,doesn't provide much comfort for those who are nowtrying to unload real estate after being enveloped in the Fed's liquidity-driven housing bubble.

To get a handle on where we are and where the Fed may begoing, let's look at the entire Greenspan era: Were there othermistakes or perverse policy patterns between August 1987 andJanuary 2006? The easiest way to do this is to measure thetrend rate of growth in nominal final sales to U.S. purchasersand then examine deviations from that trend. DuringGreenspan's tenure nominal final sales grew at a 5.4% annualrate. This reflects a combination of real sales growth of 3% andinflation of 2.4%.

The first deviation from the trend began shortly after AlanGreenspan became chairman. In response to the October 1987stock market crash, the Fed turned on its money pump, andover the next year final sales shot up by 7.5%, well above thetrend line. Having gone too far, the Fed then lurched back in theother direction. The ensuing Fed tightening produced a mildrecession in 1991.

From 1992 through 1997growth in the nominal valueof final sales was quite stable.But successive collapses incertain Asian currencies, theRussian ruble, the Long TermCapital hedge fund and finallythe Brazilian real triggeredanother excessive Fed liquidityinjection and a boom innominal final sales. This wasfollowed by another round ofFed tightening, which coincidedwith the bursting of the equity bubble in 2000 and then anear recession in 2001.

The last big jump in nominal final sales was set off by theFed's liquidity injection to fend off the false deflation scare in2002. And as night follows day the Fed started putting on thebrakes in 2004, and final sales are rapidly slowing, with growthover the past year at 5.6%.The Fed's zigzag pattern is clear: an overreaction to a socalledcrisis, resulting in the excessive injection of liquidity (asales boom), followed by a slow draining of liquidity and a mildrecession (sales slump).

The problem for investors this time around is that the economyis only starting to search for a bottom. But you wouldn'tknow it by looking at the way risks are priced. Risk is cheap.Specifically, the cost of purchasing credit protection againstthe nonpayment of corporate debt (with a credit default swap)has recently reached an alltime low. The best way for investorsto protect themselves from the Fed's oversteering is to build acore position in Treasury Inflation-Protected Securities. TIPSgenerate a real yield of 2.3% at the 10-year maturity and 2.2%at 20 years.

Steve H. Hanke

Steve H. Hanke is a Professor of Applied Economics at the Johns Hopkins University. He is a well-known currency and commodity trader and reformer who presided over the world's best-performing emerging market mutual fund in 1995.