Monetary Crack and The Fix: Inflation Targeting

The two graphs above tell a very interesting story:

1. In 2000, the Fed Funds target rate was 6.5% and the money supply (M1) was $1.1 trillion (see top chart above, click to enlarge).

2. In response to the recession of 2001 and the subsequent "jobless recovery" in 2002 and 2003, the Fed lowered its target Fed Funds rate to 1% by mid-2003 using expansionary monetary policy that increased the money supply by 27%, to $1.375 trillion by 2004 (see top chart above). In dollar terms, that was an injection into the economy of $275 billion, or almost $1000 of additional M1 ("monetary crack," see below) per person in the economy!

3. In the process of implementing expansionary monetary policy to lower the Fed Funds rate by 5.5% (from 6.5% to 1%) and expanding the money supply by 27%, the value of the U.S. Dollar (Trade Weighted Exchange Index: Major Currencies) has fallen by almost 31% since early 2002.

From Don Luskin, writing on the Fed's recent rate cut to 4.75%:

1. The crisis in credit markets is a direct result of the unwinding of speculative excesses that were set in motion in the first instance by the Fed's having kept interest rates so low for so long.

2. By lowering interest rates, the Fed effectively increases the quantity of money liquidity in the financial system, and risks increasing inflation as a result. The reactions to the Fed's rate cut this week of surging gold and oil prices, and a dollar falling to all-time lows on forex markets, confirms that there are serious inflationary consequences in our future.

3. Inflation is monetary crack - it promotes short-term euphoria, but in the end leads to ruin. Any short run growth effect will be more than offset by the dislocations and arbitrary transfers of wealth created by higher inflation, and ultimately by ruinously high interest rates that the Fed will eventually have to enforce in order to rein in the inflation it has created.

MP: Solution for monetary crack? The U.S. should go "cold turkey" and adopt an offical "Inflation Target" for monetary policy, like Canada, New Zealand, Australia, Switzerland, the U.K. and others (24 countries have inflation target). Notice that the currencies of countries listed above all have stable currencies that are at close to all-time highs, or at 10-20 year highs, against the falling dollar.