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Thoughts on monetary policy and productivity




Using the latest productivity numbers (productivity was down slightly in Q2/10, after having risen very strongly for the previous five quarters) and the latest GDP revisions, I've updated this chart that has been a long-time favorite of mine. The blue line represents the running 2-yr annualized growth rate in nonfarm productivity (this smooths out the typically volatile quarter-to-quarter changes), while the red line represents the year over year inflation rate as measured by the GDP deflator, which in turn is the broadest measure of inflation available.

What the chart purports to show is that there is a strong tendency for productivity and inflation to move inversely. Periods of declining and low inflation tend to be periods during which productivity is rising and generally strong—with the 1995-2003 period being a classic example. Periods of rising and high inflation tend to be periods during which productivity is volatile and generally low—with the 1970s being the classic example.

This relationship holds, I believe, because low inflation tends to focus people's attention on productive investments at the same time it promotes confidence by delivering stability, while high inflation tends to encourage speculative investments and discourage investment because it increases uncertainty. If prices are generally stable, for example, then it is difficult to make money by buying commodities, and the only real game in town is making money the hard way, by working harder and doing things more efficiently. If on the other hand prices are rising, then it becomes easier to make money by speculating in commodities, and it becomes very difficult to work more efficiently or to take on long-term investments because one loses confidence in the future. During the 4 years I lived in Argentina the inflation rate was well over 100% per year, and I can personally vouch for the fact that investment horizons shrink dramatically as inflation rises, and the business of life eventually becomes reduced to survival rather than planning and saving for the future.

I note that the chart is suggesting (still early to call this for sure, but it's tempting nonetheless) that we could be entering a new period of rising inflation and declining productivity. That's essentially the scenario I've been calling for since early last year—rising inflation and a subpar recovery.

How would this work? Easy money is likely to give us rising inflation, while oppressive government (e.g., the 25% increase in federal spending relative to GDP that Obama's budget is projecting) is likely to give us declining productivity.

I raise this issue because it is timely, with all the talk these days focused on the economy's presumed "loss of momentum" in the past several months. Most observers want the Fed to take steps to make money cheaper and for a longer period, in the belief that the economy is being starved for liquidity and the banking system is failing to pump out loans. From my perspective the Fed is not the culprit, if indeed the economy is losing momentum and slowing down. The Fed's easy money has helped commodity prices rise impressively, and the trillion dollars of bank reserves that are currently sitting idle at the Fed send shivers up the spine of investors and businesses everywhere, as we worry about the endgame of this unprecedented experiment in quantitative easing. I think easy money is part of the problem, not the solution. The op-ed in today's WSJ, "The False Fed Savior," agrees with me.

Monetarists, classical economists, and supply-siders all believe that monetary policy is essentially powerless to create growth out of thin air. You can't print your way to prosperity, since pumping unwanted money into the economy only creates inflation, not growth. In the same vein, monetary policy is a very poor tool for fine-tuning economic growth. Monetary policy tends to be a blunt instrument: the Fed tightens policy in order to fight inflation, and eventually policy becomes so tight that the economy falls into a recession—that's been the story of every post-war recession with the possible exception of the last recession. Monetary policy can become an obstacle or impediment to growth if it is incorrectly managed, but it can't call up growth from the ether. Good monetary policy can facilitate growth because it inspires confidence and that results in more investment and risk-taking, while bad monetary policy can kill growth because it creates uncertainty and that can shut down investment.

So I would like to see the Fed address its limitations today, rather than launch some new QE2 program. Ideally, the Fed should point the finger at Congress, since fiscal policy has been and promises to be a huge obstacle to progress. Only a more business-friendly and investor-friendly shift in fiscal policy can brighten the outlook for growth. The Fed can't and shouldn't try to do more than it has already.

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