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The Federal Reserve, at least twice in its 78-year history, has committed monumental policy errors that appeared initially to policymakers as puzzles. The first was the Great Depression of the 1930s; the second was the 'stagflation' (double-digit inflation and unemployment) of the late 1970s.

Non-Keynesian free market economists played leading roles in providing answers to solve both puzzles. Earlier Arkansas Policy Foundation reports have explained the Mises-Hayek explanation of the business cycle, and its importance in understanding current macroeconomic developments. Chicago School monetarist Milton Friedman had an even more profound influence on the central bank. Friedman won the 1976 Nobel Prize for "his achievements" in "monetary history," including a critical analysis of the Fed's contraction of the money supply in the Great Depression. Several years after Friedman won his laureate the Fed adopted his policy recommendation of pursing a tight monetary policy that targeted aggregates to restrain inflation.

The St. Louis Fed, which includes Arkansas, was a bastion of Friedmanite monetarism in the 1970s. The late 1970s were a period of internal soul-searching for some economists at the U.S. central bank. The Minneapolis Fed captured the spirit of the times, publishing a 1977 document, 'Questioning Federal Reserve Policies.' Minneapolis Fed President Mark H. Willes, in 1980, remarked, "Nobody is very happy with the conduct of monetary policy. The economy has performed badly, particularly in terms of inflation and the large costs that go with it ... The critical questions now are, 'Can and will the Federal Reserve do better in the future? My own assessment is that we clearly can do better than we have, but it is too soon to tell whether we really will."

Remarks by Fed officials before tomorrow's (Dec. 11) Federal Open Market Committee meeting suggest another period of introspection could be underway. The FOMC is expected to cut the intended Fed Funds rate for the 11th time this year to 1.75 percent (it stood at 6.5 percent in January). The issue defined: Could asset-price deflation in a period of low interest rates restrict monetary authorities?

The Fed officials' remarks are noteworthy for their appeal for intellectual assistance. One FOMC member bluntly describes events of "the past several years" as a"puzzle." Our Aug. 11 commentary ("Thoughts on Deflation") described Fed Chairman Alan Greenspan's unusual summer reference to "asset-price deflation," and contrasted it with a negative consumer price index (CPI). There is evidence of asset-price deflation in the economy. "Thinking about deflation," we concluded, "could lead many to carefully examine their own balance sheets and assumptions about credit and the economy ... Debt reduction constitutes preparation for deflation." The domestic personal savings rate (U.S. Department of Commerce) fell to 7.5 percent in the last recession (1990-1991). By contrast, it was 0.2 percent in October 2001. Asset price deflation in a recession could prove problematic for many.

Two FOMC members have mentioned the topic in the past two weeks. Fed Governor Laurence H. Meyer said Nov. 27 in St. Louis, "(W)e were still struggling to understand the severity of the slowdown and the prospects for recovery before Sept. 11." In remarks to the National Association of Business Economics Meyer mentioned deflation. Meyer said, "Given the initial low level of the nominal federal funds rate (pre-Sept. 11), we face the risk that, in what is arguably a worst-case scenario, that rate could be driven to zero, the practical limit for a nominal interest rate ... In my view, the appropriate policy response, when confronted with such a potential limit, is to respond especially aggressively to any adverse demand shock, in effect, substituting speed of the move for the cumulative size of the easing." (Note: the nominal, or money rate of interest, is a misleading barometer of what borrowers pay and lenders receive due to inflation. The real rate, a more accurate indicator, is the nominal rate minus the expected inflation rate.)

Mr. Meyer continued, "The danger in waiting is that inflation might drift lower, limiting the ability to drive the real federal funds rate into negative territory, as might be necessary to support a timely recovery. In the worst case, as in Japan today, inflation might turn to deflation, limiting the ability to lower the real policy rate even to zero."

Most significantly, Fed Governor Edward M. Gramlich said Nov. 29 in Paris, "Recent changes in asset valuations have been enormous, and they appear to have had substantial effects on the economy ..." His speech focused on attempts to understand consumer spending spurred by "the wealth effects of rising asset prices in equities and residential real estate." Gramlich continued, "(T)he substantial gains in housing wealth that have been experienced in recent years and the disparate movement of house and equity prices make this an issue of both policy and academic interest." He concluded, "(T)here is no question that asset prices influence the macroeconomy," describing changes to it as a "puzzle."

The comments by Mr. Greenspan, Mr. Meyer and Mr. Gramlich illustrate Fed officials are curious about the effect rising or falling asset prices, including equities and real estate; have on consumer spending and the real economy. FOMC minutes are made available within a few days of the next regularly scheduled meeting (Jan. 29-30, 2002). Yet raw transcripts of FOMC meetings are embargoed for five years. Absent a policy change toward greater Fed transparency the full story will not be known until 2007.

The Cleveland Federal Reserve (Ohio and portions of Kentucky, Pennsylvania and West Virginia) is today closest to playing the role the Minneapolis branch did in the 1970s. Mr. Jerry L. Jordan, an ex-St. Louis Fed economist (1967-1975) who rose to senior vice president and director of research, is Cleveland Fed president and FOMC alternate member. He served as a member of President Reagan's Council of Economic Advisers (1981-82) and on the U.S. Gold Commission.

The Cleveland Fed, in the free market tradition, has published at least seven research pieces since 1997 that reference asset-price deflation. The most recent, the bank's June 2001 'Economic Trends,' starts to define the issue, "Asset price bubbles, like those in the tech stocks, can be recognized only after they burst. Nevertheless, policymakers can and often do lean against the economic winds that generally accompany speculative excesses. When stock prices correct abruptly, policymakers may act aggressively to keep asset-price deflation from threatening economic stability. But monetary policy takes effect only after long and variable lags."

The Cleveland bank's 1998 annual report ( takes the analysis a step further, asking, 'Do Stable Prices Imply That Monetary Policy Is Stabilizing?' The report states, "The argument that price stability is not a sufficient condition for sustainable growth has been made by observers of economic fluctuations since before the Great Depression. Other scholars who analyzed the "great contraction" of the 1930s (A.G.B. Fisher, Ralph Hawtrey, Gottfried Haberler, F.A. Hayek, Ludwig von Mises, and A.C. Pigou) all concluded that the absence of consumer price inflation in the 1920s sent false signals about financial and economic stability ... There is no general consensus among economists as to what caused the 'great contraction' of the 1930s, but one school of thought is that the seeds were sown during the prior boom."

The Cleveland Fed's analysis is relevant given current events. It is ironic that Mr. Jordan's first FOMC meeting (March 31, 1992) was the occasion of one of the panel's last known discussions (under the embargo rule, pre-1997 transcripts are unavailable) of asset-price deflation. The U.S. economy, at the time, had clearly emerged from an eight-month recession (1990-1991) affected by asset-price deflation in the real estate market.

A longer, and more detailed discussion occurred four months earlier at the Nov. 5, 1991 FOMC meeting. Mr. Greenspan observed, "This is an old fashioned asset contraction. It is reflected most severely in the commercial real estate area, with obvious consequences in the financial sector as we discussed. It's reflected, strangely, in the residential single family area even though the data themselves scarcely suggest anything close to the asset-price deflation in commercial real estate." Fed Governor Wayne Angell (Kansas City, 1986-1994) noted, "Asset prices need to adjust to a different level of expected inflation. And in some ways the faster these asset price adjustments take place the better the recovery."

Fed Governor David W. Mullins, Jr., (St. Louis, 1990-1994), an Arkansas native, told fellow FOMC members, "I guess I agree with the basic diagnosis that we're experiencing a gradual wringing out of the excesses of the '80s and that that is impacting downward pressure on growth." Later, Mr. Mullins said,"We've seen those excesses, and people are talking about an asset deflation in real estate. Expectations of inflationary home prices have collapsed, and I agree with those who think that that has had a profound impact on consensus since that's probably the single most important component of their wealth. And I do agree that the leverage also was an excess."

Could the Fed be underestimating the possibility of asset-price deflation? Phrases like "still struggling," and "the puzzle," uttered recently by FOMC officials, point to an alternative explanation: An emerging research agenda that seeks to develop a better understanding of asset-price deflation. The Cleveland Fed is a leading candidate for this role.

--Greg Kaza