Wednesday, September 24, 2008

Forecasting the Inflation Rate

For an extended period of time (from about 1948 to 1980) the management of the U.S. financial system stayed relatively constant in terms of innovation. By that I mean we didn't come up with concepts like NOW accounts during that period. Since then, of course, innovation and change have been rampant.

Effective Reserves Determined Inflation

During that thirty years or so, the Federal Reserve's operating system was stable enough that it became possible to pick out patterns. This is why there were so many monetarists in the late 70's, and so few today. The patterns have more or less been obliterated by the many changes made to the system since then.

One pattern was the six-month lag of overall economic activity to changes in Effective Reserves that I mentioned in the last post. Another was the overall level of prices relative to Effective Reserves. Note that I am talking about the "overall level of prices" here, and not just the inflation rate, i.e, not just the rate of change in overall prices.

Stated another way, if the level of Effective Reserves started at an indexed value of 100 in 1950 and moved to an index value of 150 over the next ten years, then the price level also tended to move upward by about 50% during a ten-year span, but lagging Effective Reserves by about three years.

A Great Example

In about 1972, President Nixon imposed wage-price controls on the U.S. economy. During the next several years, the inflation rate was muted regardless of the fact that Effective Reserve growth continued apace. By the time wage-price controls were removed, a significant gap had opened between the level of Effective Reserves and the level of the GNP Deflator. During the next several years, Effective Reserve growth was brought under control by the Volcker Fed, but the GNP Deflator began rising at a faster and faster rate.

This led to the double-digit inflation of the late 1970's, while the tighter reserve growth combined with that inflation to give us interest rates on U.S. Government Bonds that approached 15% for a time! What I was looking at was an Effective Reserve number that implied that inflation was rapidly coming under control, even though the reported inflation rate was in double digits. So I bought some 13.25% long treasury bonds, and at a modest discount to boot. As most of you no doubt realize, the inflation rate then began its long decline toward near zero a decade or so later.

One Tentative Conclusion

I watched the Effective Reserve number long enough, and the GNP Deflator's reaction to it, to form an opinion. My conclusion was that a given percentage increase in Effective Reserves resulted in a more or less identical increase in the GDP Deflator, though with a significant lag of several years. This bothered me some because it would seem that as the economy grew it would require a larger and larger level of money supply (and hence reserves) to support the higher level of economic activity. Then I realized that a case could be made that just as operating companies increase their productivity at an average rate of 2-4% annually, so might the banking system. In other words, each year they would make enough improvements in procedures (electronic checking, etc.) to enable the system to support the increase in overall economic activity without requiring added reserves for the banking system.

In the next few posts, I'll discuss how Effective Reserves are added to the system. It's not as clear cut as the textbooks imply.

Next Post: Monetary Policy, Pushing on a String - Not!

No comments: