The Fed Is a Threat to Growth (Stephen Moore, Louis Woodhill, WSJ)
Last Modified: 02:11 AM, Thu Mar 14, 2019
14 March 2019

Now that the Trump administration appears to be closing in on a trade deal with China, and thus hopefully averting a damaging tariff war, the U.S. economy is positioned to grow at 3% to 4% over the next several years. The Tax Cuts and Jobs Act of 2017 and two full years of pro-business regulatory relief already ramped up growth to 3.1% over the past four reported quarters -- the best performance since 2005.

The last major obstacle to staying on this path is the deflationary monetary policy of the Federal Reserve. The deflation began with quarter-point interest-rate increases in September and December. These hikes caused a severe dollar shortage, a fall in commodity prices, and a rapid slowing of growth -- accompanied by wild swings in the stock market.

The rate increases came after the economy last summer reached a 4% annualized rate of growth and a 50-year low in unemployment, accompanied by real wage gains -- all without spiking inflation. It's hard to see what the Fed didn't like about this economic picture. What problem were they trying to solve with the hikes?

Markets reacted violently to the Fed's inexplicable interest-rate increases, sending the price of commodities tumbling by 15%, including everything from oil, soybeans and orange juice to steel, lumber and copper. Stocks fell by the same amount in nominal terms, pushed down by deflation. The market turbulence wasn't a reflection of weakness in the real economy. It was all the Fed's doing.

Even the consumer-price index has been flat or slightly negative for the past three months, and inflation remains way below the Fed's 2% target. The latest Treasury inflation-protected securities spread indicates investors believe inflation will stay below the Fed's target for many years to come.

When the Fed finally admitted its money-tightening mistakes in late December and announced it would forgo its planned rate increases, the deflation stopped and the stock market largely recovered, in tandem with commodity prices. But the damage was done and growth hasn't resumed. Commodity prices remain 10% below where they were before the September rate hike.

Tight money and slow growth have seemed to go hand in hand. The near 4% growth of the second and third quarters of 2018 slowed to 2.6% in the fourth quarter. The Atlanta Fed's latest growth forecast for the current quarter is down to 0.4%. Industrial production has fallen, as have consumer spending and small-business confidence.

The Trump administration's pro-growth policies have attracted investment from around the globe, triggering a spurt of demand for dollars at the same moment the Fed began sucking dollars out of the economy. This combination of a reduced supply and heightened demand for dollars produced an entirely unnecessary deflation. When President Trump fumed that the Fed's rate increases were smothering his growth policies, he wasn't entirely wrong.

The solution is obvious. The Fed should stabilize the value of the dollar by adopting the commodity-price rule used successfully by former Fed chief Paul Volcker. To break the crippling inflation of the 1970s, Mr. Volcker linked Fed monetary policy to real-time changes in commodity prices. When commodity prices rose, Mr. Volcker saw inflation coming and increased interest rates. When commodities fell in price, he lowered rates.

If the Fed had been doing this (by lowering the interest rate on bank reserves), the recent wild stock market gyrations likely wouldn't have occurred, and growth wouldn't be slowing. We estimate that the Fed's deflation has already chopped 1 to 1.5 percentage points off real growth over the past six months. Deflation is a prosperity killer.

This isn't to say that money is the only factor that drives the stock market or the real economy. As we noted, the demand for dollars is itself driven -- both positively and negatively -- by fiscal, trade and regulatory policy shifts, along with technological change, productivity, labor-force growth and innovation.

The Fed's goal should be to avoid excessively loose or tight money by seeking stable commodity prices. Yes, there will always be sudden spikes and dips of certain commodities -- as when the Organization of the Petroleum Exporting Countries holds back oil supply to drive up the price. The value of using an index of some 19 commodities is that no one can manipulate all of them at once. The direction of a composite commodity-price index is driven almost solely by the dollar. This is a lesson that the late Robert L. Bartley, editor of these pages, taught us in the 1970s and 1980s in correctly explaining surging oil prices, but one that seems to have been forgotten.

Skeptics in and out of the Fed still think sustained 3% to 4% growth is out of reach. Nonsense. The combination of stable prices and sharp tax cuts in the 1980s produced an average of 4% growth for seven years. Imagine if we had a similar stretch of sustained growth, with low inflation and rising wages. Messrs. Trump and Powell would rightly be heralded as economic saviors.

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Mr. Moore, a senior fellow at the Heritage Foundation, was a senior economic adviser to the Trump campaign. Mr. Woodhill is a Houston-based entrepreneur and angel investor in startup companies.

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