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September 11, 2006
Growth Doesn't Cause Inflation

All through the late '90's as I was running EMusic, I remember the constant drum beat from policymakers that somehow spectacular growth that was occurring all around us was driving up inflation. I surmise that it was some odd effect of the Philips Curve model that the Fed uses. What really drove me nuts is that this was being stated as gospel while I was watching huge capital influxes into various vertical industries drive tremendous competition and dramatically lower margins and pricing power. How could inflation rise when no firm I know of had pricing power?

This morning I received a great Monday Morning Outlook from Brian Wesbury and Bill Mulvihill. Quoting at length:

Because lags between changes in Fed policy and overall inflation can take up to two years, understanding today requires us to step back in time. The story begins in 1999, when the Fed feared that high stock prices and an overheating economy were inflationary.

This view was mistaken for two reasons. First, growth does not cause inflation. With commodity prices low, and falling, in the late 1990s the Fed should not have fretted that policy was too easy.

Secondly, Y2K caused the Fed and markets some confusion. Massive demand for high-tech equipment and software boosted spending above trend. Investors priced into many high-tech stocks ongoing growth rates in sales of 50% or 60%, while the Fed made the assumption that this growth, and some pricing pressures that it created, were permanent.

Between June 1999 and June 2000, the Fed hiked the federal funds rate from 4.75% to 6.5%. The real federal funds rate peaked at 4.0% - a very tight policy. This mistake caused deflation, recession and a collapse in the stock market.

This also leads me to want to pull excel out and do a price of oil as adjusted to gold ounces so I have a more rational basis to talk about the real cost of oil/gas over the last 5 years. Maybe if I have time.

A hat tip to Steve Conover at Skeptical Optimist who put me on to these guys in the first place. He's worth visiting as he's also talking about energy in an ongoing three part series.

Posted by hoffmang | September 11, 2006 12:37 PM


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