A troubling quotation

In testimony last week, Fed Chairman Ben Bernanke told Congress that "inflation could be lower than we anticipate if slower-than-expected global growth moderates the pressure on the prices of energy and other commodities or if rates of domestic resource utilization fall more than we currently expect."

The troubling aspect of this quotation lies in its indication that Ben Bernanke, and therefore possibly many members of the Federal Reserve Board, believes that slower growth reduces inflation and faster growth increases inflation. Back in the 1960s and 1970s, central bankers around the world, including the Fed, held to a related belief that there is an inverse relationship between inflation and unemployment. This supposed relationship is often called the Phillips Curve, after the author of a 1958 paper on the subject.

The Phillips Curve was discredited in the 1970s, when unemployment and inflation rose in tandem. Thanks to the efforts of economists such as Milton Friedman, who argued that inflation is a monetary phenomenon (not a by-product of growth and employment), the stagflation of the 1970s was reversed and the current era of relatively stable money ensued. This enabled the explosive business growth of the 1980s and 1990s which has benefited so many people.

The quotation above from Mr. Bernanke's testimony before Congress is therefore very troubling because conducting monetary policy based on this flawed logic will do much to destablilize the dollar. Belief that a slowing economy will contain inflation may give the Fed justification to lower rates to try to stoke the economy. This is in fact the course the Fed has chosen and will probably continue when they meet again on March 18.

The Fed controls the money supply, and since inflation is a monetary phenomenon, the economy is at the mercy of the Fed to control the money supply in a manner that would provide a stable currency. The demand-side view that the Fed should be tinkering with the economy by trying to make it speed up or slow down is wrong-headed, a relic of the Phillips Curve era that should have been abandoned after the 1970's. If the Fed provides businesses with a predictable, stable currency, then businesses will grow the economy, not the central bankers. Unfortunately, political pressures seem to get the better of the well-meaning members of the Fed's Board and volatile monetary policy is what we end up with.

Many economic problems have been created by the Fed trying to steer the economy faster or slower using monetary policy, including the current credit crisis (caused in large part by the Greenspan Fed's decision to lower rates to 1% and hold them there for thirteen months) and the market plunge of 2001 (caused in part by the Grenspan Fed's decision to raise rates to 6.25% in order to put the brakes on what Alan Greenspan called "irrational exuberance").

The quotation above from last week's Fed testimony indicates that there may be more Fed-induced problems to come, until the lessons of the 1970s are learned and the counsel of the late Milton Friedman is again heeded.

(We wrote about the divide between the supply-side and demand-side approach to economics in several previous posts, such as this one).

For later blog posts dealing with this same subject, see also:

• "The Fed drops the mask" 08/25/2008.

• "Stand still, little lambs, to be shorn!" 06/03/2009.

• "Milton Friedman, 1912 - 2006" 07/31/2009.

• "Inflation is a monetary phenomenon" 03/07/2011.