Thursday, June 19, 2003

The Financial Times has an extended commentary (again, pay-only -- sorry) today about Greenspan and the opening of "a new chapter in the history of central banking" in which the focus is no longer inflation but formally and officially deflation.

The trigger for this "new chapter" is next week's much-anticipated 25 basis point drop in the federal funds rate, which will bring the Fed's interest rates down to 1.0%. The possibility of a dramatic 50 basis point cut is unlikely but not out of the question either, which would lower interest rates to 0.75%.

What makes this all particularly interesting is, in the words of the FT, "Recent intense internal debate has led the Fed to question its earlier confidence that deflation could always be prevented." In other words, it not just about the money supply.
as the debate has evolved, concerns have emerged at the Fed about this blithe assurance that central banks can always create inflation if they choose. Fed officials used briskly to reject comparisons with Japan, which has struggled with deflation for a decade despite cutting interest rates to near-zero and pumping huge amounts of money into its economy. Now, they are less certain. The spectre of a 1930s-style "liquidity trap" - where efforts to create money have no effect on the economy - has loomed larger.
What is amazing to the General is how in the 1990s economics has become more and more a branch of psychology, except one populated almost completely by amateurs, dabblers and pop psychologist cranks. To avoid the liquidity trap, the Fed is now fully in for "managing expectations"; what you do is far less important than how the markets think about what you do. Of course, this has always been The Maestro's forte, but the task is now far larger and failure more ominous. And since 2000 we've learned that Greenspan isn't exactly Midas despite his continued lionization.

There is still little appreciateion for the consequences of flooding the country with cheap money on another stock market bubble or the existing housing bubble. The Fed also seems to neglect the important historical context of previous post-WWII interventions to prevent deflation in the 1940s. Today not only the US but the world is in structural deflation much like the late 19th century. Our lessons won't be coming from the era of Keynes but rather the era of the Robber Barons -- in more ways than one.


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