Back in early March, we noted a troubling quotation indicating that the Chairman of the Federal Reserve, and possibly many other members of the board, believed that slower growth reduces inflation and faster growth increases it.
We noted that this discredited notion held sway through the inflationary 1960s and 1970s until Paul Volcker put into practice the theory advanced by Milton Friedman -- that inflation is strictly a monetary phenomenon and will not melt away by itself when economic growth slows unless monetary policy is also corrected -- and ended stagflation. The very existence of stagflation argues that slowing economic growth does not automatically contain inflation.
After the June Fed meeting, when the Fed's statement indicated that "The Committee expects inflation to moderate this year and next year," we wrote a post entitled "A Phillips-curve Fed?" The Phillips curve was the 1950s-era concept that lower employment would lead to lower inflation, and higher employment would lead to higher inflation. It was hard to believe that anyone still believed in that concept, which had caused so much inflation in the decades before 1980.
Now, however, we are forced to conclude that the Fed is, as Steve Forbes argued in June, "still in thrall to the Phillips curve." On Friday, August 22nd, Ben Bernanke gave a speech to the Federal Reserve Bank of Kansas City's Annual Symposium in Jackson Hole, Wyoming.
Coming during a week in which the inflation data was worse than at any time since 1982, Mr. Bernanke stated that moderating commodity prices and "a pace of growth that is likely to fall short of potential for a time, should lead inflation to moderate this year and next year."
This is sheer Phillips-curve thinking. It is difficult to doubt any further that the Federal Reserve is indeed under the belief that slower economic growth will of itself cause the current inflationary pressures to subside.
Instead, as we have argued previously, stable monetary policy will create the environment for business growth, while inflationary policy (such as the Fed has been pursuing for at least a year) will hinder it. By subscribing to the outdated Phillips curve, the Fed can cause the very "weakening outlook and downside risks to growth" that they think will contain inflation.
It is true that commodity prices have dropped sharply, but this is probably due to the unwinding of the speculation that was riding on the back of the actual inflation dragon. That underlying inflation is still there, and our belief that it is a monetary phenomenon means that only monetary policy can tame it.
All of this points to the fact that an investment philosophy which relies on timing the Fed, or playing the resulting moves in commodities, should not be the core of a long-term plan for building wealth. We believe that ownership of innovative, growing, smaller companies in a portfolio help weather the inevitable inflationary flare-ups. Even in troubled or inflationary times, unless you think the economy is going to shut down completely, it will often be the smaller, more nimble companies with a product or service providing new value that will be the engine of growth.
For later blog posts dealing with this same subject, see also:
- "Stand still, little lambs, to be shorn!" 06/03/2009.
- "Milton Friedman, 1912 - 2006" 07/31/2009.
- "The 97-pound weakling" 12/16/2009.
- "Ben Bernanke's non-New-Year's Resolution" 01/05/2010.
- "Avatar and long-term inflation" 03/02/2010.
- "Still in thrall to the Phillips curve?" 03/15/2010.
- "Inflation is a monetary phenomenon" 03/07/2011.
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