TCS Daily


The Fed Learns to Stop Bloodletting

By Kevin Hassett - July 24, 2000 12:00 AM

Back in the 1700s, a German-born physician known as Franz Mesmer was the hottest doctor in Paris. Mesmer, would put patients in a trance - "mesmerize" them, that is -- and then "rebalance" their magnetic fields. He was said to be able to cure most any disease. He even claimed to be able to work from a distance. The funny thing was, his patients, statistically speaking, did much better than patients who were treated by normal physicians. These facts lead to quite a craze, which ended abruptly when Benjamin Franklin, of all people, debunked Mesmer. In a controlled setting, Franklin showed that the health of Mesmer's patients was unaffected by his treatments.

Why were his statistics so good? People who visited Mesmer generally didn't visit the medical establishment, which at the time used bloodletting to cure just about everything. At least Mesmer did no harm.

The big news last week was that the Fed might have learned how to stop doing harm. Chairman Greenspan testified to Congress, and did absolutely nothing to roil the markets. He signaled clearly that he sees signs that the economy is slowing, and hinted that the fabled "soft landing" may be underway. This was a welcome relief to those of us who have been afraid that the Fed might get too carried away in its zeal to set the risk of runaway inflation as low as possible. I feared that the Chairman, who likes to signal his moves well ahead of time, would use this testimony to signal another rate hike in August. He didn't, and that's the good news that the market noted -the S&P 500 was up quite a bit the day of the speech-but I believe that the news was even better than the speech indicated.

Here is why. We learned last week that the Consumer Price Index increased a whopping 0.6 percent in June, making the year-over-year increase 3.7 percent. That is a significant surge in top-line inflation. Last January, the 12-month increase was only 2.7 percent. The June surge was mostly caused by yet another surge in energy prices, which jumped 5.6 percent. The big run-up in energy prices even spread into the prices of other goods, which have seen their inflation rate increase from about 1.9 percent last January to 2.4 percent in June. Any other Fed Chairman would have used these numbers as an excuse to crush the economy. Greenspan appears to have chosen not to.

Why did he make that choice? The best answer is that the Chairman recognizes that the surge in inflation is, all thing considered, good news. How can that be? First a little background. About 15 years ago, James Hamilton, an economist at the University of California at San Diego, wrote a paper that sent shock waves throughout the economics profession. Hamilton developed a model that was able to predict recessions. And boy was Hamilton's model good. It successfully predicted all but one of the U.S recessions since the Second World War. And the model was so simple! Hamilton related oil prices to the health of the economy, and found that sharp spikes in oil prices preceded recessions.

How could a thing like oil have such a big effect? Economists have settled on one explanation. When the price of oil increases, the price of just about everything else does too When the Fed sees prices rising, it interprets it as a surge in demand -rather than a jump in supply cost-and then raises interest rates to stave off inflation. This is analogous to bloodletting. The oil shock hurts the economy, and then the interest rate treatment pushes it over the edge. Historical evidence suggests that Fed rate hikes combined with oil shocks have caused most recessions.

How could they be so stupid? Our old friend the Phillips curve is once again the culprit. According to the Phillips curve, higher inflation is caused by higher demand for goods. If a true believer sees higher inflation, then he concludes that demand must be higher. The Phillips-curve specialists at the Fed historically saw inflation and concluded that the economy must be overheating. Whoops.
The fact is, an oil shock is a surge in supply cost. The right response for the Fed to such a surge is to do nothing. You can't stop supply side inflation without doing significant harm to the economy.

So why was the CPI report good news? Because the increase was, all things considered, pretty small. Models that predict price responses to oil shocks think inflation should be half a percentage point to a whole percentage point higher than it is now. Inflation has not accelerated because another supply shock has worked to cancel out the impact of a surge in oil prices: the IT revolution.

By holding off and not raising rates, Greenspan has signaled that he has learned the lessons of the Hamilton paper, and perhaps even learned that the New Economy is changing the rules. Thus, the possibility that the Fed might steer us into a recession with bad medicine is much smaller than it used to be.

When the economic history of this little epoque is written, I wonder whether our long run of prosperity will be attributed to the IT revolution or to something more basic. In the year 2000, the U.S. learned how not to shoot itself in the foot.
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