The Fed and the Dollar

The WSJ has written a piece that continues the much needed debate about the Fed's role in monetary policy and its relation to a steady dollar. The thoughts echoed in this piece are fairly similar to those echoed by Steve Forbes recently. The WSJ also asserts that the Fed should prioritize Dollar stabilization over economic stimulus...

When Federal Reserve governors meet today, they should consider that solutions to their twin challenges – a flagging economy and systemic moral hazard in financial markets – have common roots in a stable dollar. One of the primordial lessons of economic history is that sound money is a necessary condition to promote long-run prosperity and maximal growth. Moreover, a stable currency and low inflation lessen the need for complex hedging vehicles which can be leveraged to harmful effect in volatile markets.

The Journal adds a few other interesting pieces of context to this arguement. First, the monetary policy of the Fed is based on an old thesis known as the Phillips Curve...

To understand why it may not, and why a different path should be taken, it must be recognized that Fed policy has long been guided by – or perhaps more accurately, yoked to – the alleged trade-off between unemployment and inflation: the so-called Phillips Curve.

A.W. Phillips's original 1958 paper dealt with wage rate changes and unemployment. But eventually it would become conventional policy wisdom to apply his insight more broadly to price level movements against the unemployment rate.

In other words, the better the employment the more pressure there is on inflation and vice versa. The Journal argues though that this theory is not necessarily guided by historical data.

Since 1948, according to Bureau of Labor Statistics figures, inflation has averaged 3.7% per year, unemployment 5.6%, and real GDP growth 3.4%. But the 10 lowest inflation years (between 1949-62, and 1986) averaged 0.5% inflation and 5.2% unemployment, along with 3.5% GDP growth. And the 10 high inflation years (between 1973-81, 1969, and 1990) averaged 9.1% in consumer price increases, along with 6.2% unemployment and 2.6% in growth. In other words, low inflation was often associated with lower unemployment and stronger GDP growth than high-inflation years.

More strikingly, the years following the 10 lowest inflation years were even better in terms of performance (averaging 5.1% unemployment and 4.4% growth), and the years following the high inflation years were even worse (7% unemployment and 1.4% GDP growth). This record shows the importance of sound money, fostering an environment allowing the key growth drivers of entrepreneurship and capital investment to flourish under stable long-run expectations.

So, the Journal argues, the Fed is working on a model that says that since employment is weak there is no inflation fear. The Journal argues that this thesis is faulty. Since the thesis is faulty the Fed is following inappropriate monetary policy...

The bottom line is this: the Fed should bury its errant Phillips Curve framework, and cease attempts to fine-tune perfect balance between inflation and recession. It should halt further rate cuts and soon begin a series of interest rate increases.

In other words, much like Forbes the Journal argues that the Fed is concerned with all the wrong things. Rather than trying to provide stimulus which the Journal argues leads to loose money and thus a "moral hazard" (their term), they should concentrate on stabilizing the dollar. Forbes argues this should be the long term and consistent goal of the Fed. The Journal says much the same thing...

By discarding the Phillips Curve blinders, the Fed would happily learn that economic growth and low inflation are not a mutually exclusive trade-off. A stable dollar promotes both, along with making fiscal and moral hazard problems easier to solve in the future.

This is a much needed debate and I will continue to monitor.