WALL Street is always quick to extrapolate yesterday's headline into tomorrow's trend. Traders have naturally been encouraged by the modest increases in prices lately. The broadest price measure, the fixed-weight deflator for gross domestic product, rose at a rate of only 2.1 percent in the fourth quarter.
The outsized increase in the Consumer Price Index for March (increasing at an annual rate of 6.2 percent) was both an aberration and a warning. It was an aberration in that it is not likely to be sustained. It is a warning in that higher inflation rates are likely in the long term.
The Federal Reserve's aggressive easy money policy provides part of the upward inflationary pressure. Total bank reserves rose at a rate of almost 27 percent in the first quarter, the second highest quarterly gain since World War II. More insidious for financial markets, is the push for even easier money. While the reported rate of change in prices has declined, political pressure to debase the currency has increased. Investors should watch out for debris from falling bond prices.
Every bear market is punctuated by trading rallies. The long slide in bond prices that is now a prospect will be no exception. Investors should approach such periodic surges with caution. In the absence of political support, the notion of sustained disinflation is little more than wishful thinking. Investors should shorten the duration of portfolios to take advantage of the trend to lower bond prices. The stock market, meanwhile, will have to contend with the tug-of-war between corporate profits - which are set to explode in 1992 and 1993 - and the downward drag from higher rates.
Robert Reno, a columnist for the Times-Mirror newspapers, makes the conventional case for easy money: "Real interest rates remain high," he says, "exceedingly high for a period in which economic contraction cries out for monetary stimulus.... Clearly the costs ... of carrying on this insane war against inflation far exceed any negligible benefit."
Real rates are actually far below where they were in 1983 when real output soared almost 7 percent. Such errors in arithmetic aside, pumping up the money supply is the one sure-fire formula to increase interest rates. The faster the monetary authorities run their printing press, the more rates will go up as investors seek to preserve the value of their principal. This is why bond prices declined substantially in the first quarter, despite low inflation and slack credit demand. Furthermore, underlying inf lationary pressures are not as weak as they appear. Core inflation (minus food and fuel) was 4.5 percent from fourth quarter 1990 to fourth quarter 1991, roughly equal to the average since 1983.
Over time, excess money growth causes inflation. Still, the fact that core inflation and employment costs are going up at the same rate is very significant. It is plain that as disinflation bites into wages, political resistance to the process will increase.
Indeed, with the federal deficit running at a annual rate of nearly $400 billion, disinflation may be impossible. When the government disburses real benefits, someone, sometime must pay a real tax. Since Congress refuses to restrain outlays or impose explicit taxes sufficient to balance the books, the Federal Reserve has to do the job. The central bank transfers real resources to the government by creating inflation, which reduces the real value of outstanding federal debt. This amounts to an unlegislate d, unconstitutional tax increase.
Lawrence Lindsey, the junior member of the Federal Reserve, is right that "there is no attractive long-term policy trade-off between unemployment and inflation," and that "low inflation may actually enhance economic performance." Investors know from bitter experience, however, that what counts is not what Fed officials say, but what they do. At present, they are printing money at an excessive rate by pegging the Fed funds rate at 3.75 percent. In effect, the central bank is offering to sell bank reserves
at a bargain. There are no limits on reserve creation. The only true rein on the creation of money is the desire of the American people for stable prices.