Making an Accurate Prediction About the Economy

When one understands what really causes inflation, and what effect inflation has on an economy, making accurate predictions about how the economy is going to do going forward becomes much easier. That is why today most economists predictions about the economy are worthless. Most economists today do not understand what inflation really is, so they have little or no hope of making accurate economic predictions consistently.

I wrote the following last October about the economy:


As is starting to become evident, our economy is slowing down rather dramatically. The Federal Reserve will, of course, blame higher energy prices and the hurricanes as the causes. Complete and utter nonsense.

It is the Federal Reserve’s actions over the past year and a half which are now causing the slowdown. The Federal Reserve has nearly Quadrupled the fed funds rate over this short time frame, which is the overwhelming factor in the economy slowing. The main questions going forward are how much will the economy slow and will the Federal Reserve continue on until it causes yet another recession?

The stated purposes of the Federal Reserve for raising the fed funds rate so dramatically are price stability and to contain inflation. The facts clearly show that the Federal Reserve’s actions and its stated reasons for those actions are at cross purposes. In order to show this let’s look at two economies.

Japan for well over a decade has had nominal interest rates. Rates that the Federal Reserve would call “accommodative”. According to the logic the Federal Reserve is following today, Japan must have had high inflation and no price stability. In fact, just the opposite is the case as Japan has had no inflation and relative price stability.

The German economy, especially prior to the formation of the European Union, has had high interest rates. According to the logic the Federal Reserve is following today, Germany must have no inflation and price stability. In fact, Germany, despite the high rates, has been struggling with persistent inflation above what it wants.

Both economies have been struggling with low growth and high unemployment.

The reason why both Japan and Germany have had economic problems is simple. Both are trying to control interest rates instead of letting the market do so. By setting interest rates, and not letting the market do so, both are interfering with the natural growth rate of money.

In Japan’s case, by keeping rates too low, all of the trillions of yen in financial institutions are earning little or no interest, causing very little natural money supply growth.

In Germany’s case, the above market rates are causing all the marks in financial institutions to earn more interest than they should, causing natural money growth to be higher than it should be, causing the nagging inflation that is higher than Germany wants.

In our economy over the last year and a half, we have seen both sides of the coin. The Federal Reserve had interest rates too low, causing money growth to be low as well as inflation and job growth to be low. Since, the Federal Reserve has raised rates, to the point where they are now too high, which will cause persistent and nagging inflation to be above what the Federal Reserve would like, and slowing growth and, unfortunately and almost certainly, causing job growth to disappear.

Today the Federal Reserve has trapped itself. It raised short term rates to keep inflation in check, but by raising rates above where they belong the Federal Reserve is also causing natural money growth to be higher than it should be. Once again we see a case where the Federal Reserve is fighting itself. Going forward, as inflation numbers stay persistently above what the Federal Reserve wants, the Federal Reserve will continue to raise rates, eventually choking off all economic growth.

The facts are clear. If the Federal Reserve really wants to keep inflation low, it should LOWER the fed funds rate today. A year and half ago I wrote that in order for the economy to have better economic and job growth the Federal Reserve needed to RAISE the fed funds rate, not lower it to zero (as the Fed said it would do at the time and almost all economists at the time said it should do). Today, in order to accomplish its stated goals of price stability and no inflation, the Federal Reserve needs to LOWER short term rates to where they would naturally go if the Federal Reserve was not trying to manipulate them.

As the facts turned out I was right a year and half ago, as the Federal Reserve raised short term rates and economic and job growth picked up smartly. Unfortunately, and it saddens me greatly, but I will be shown to be right again.


- October 11, 2005