For Less Inflation, Try Less Money

When Walt Disney World hikes the admission price for 10-year-olds from $31 to $41, it's time to begin worrying about inflation. Nearly every measure of core inflation is rising, from import prices to the consumer price index. More and more companies are raising prices and making them stick. A National Association of Business Economics survey shows pay hikes are at an 11-year high. The employment cost index is up. While prices on some products are falling, cyclical pressures from fast U.S. growth and a sharp recovery in Asia and Europe are pushing others up. The Federal Reserve is caught in a bind. Volatile stock markets that crash one day and soar the next may be signaling serious trouble ahead and require a light touch on monetary policy. But rising inflation demands serious tightening. Our advice to the Fed: keep the focus on inflation.

The Fed itself has contributed to the wild ride in Nasdaq stocks by flooding the system with liquidity to stave off potential financial crises. Much of that liquidity has become the froth of stock speculation. The first crisis was the Asian meltdown of 1997. In the face of a threat to the global financial system, the Fed cut rates three times in the final three months of that year. (Central banks around the world cut rates a total of 68 times.) This was clearly the right move at the time.

But then the Fed decided to broker a bailout of the Long-Term Capital Management hedge fund, which collapsed as a result of the crisis. By the fall of 1998, when Russia defaulted, some investors were thinking the Fed would save them from their own poor decisions in the future. The Fed cut rates three more times. The added surge in the money supply supported a strong rally in stock prices.

Then came the Y2K scare. The Fed printed an extra $50 billion to allay fears of a bank run, leading the growth rate of the money supply to jump from 5% to 15% by the end of 1999. True, the Fed was not alone in overestimating the seriousness of the Y2K problem, but its actions helped send the Nasdaq to the stratosphere. The extra liquidity also lit a fire under the economy, which grew at 7.3% in the fourth quarter of last year.

The Fed has since been mopping up excess liquidity. It has done a good job so far, but it has a ways to go. Unless the markets begin to spiral down in a free fall, the Fed should tough it out and steadily reduce the rate of money-supply growth. This will contain speculation, cool the economy, and fight off the threat of cyclical inflation.

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