In 1973, when I was a young pup just starting out as an open-market-operations economic analyst at the Federal Reserve Bank of New York, deflationary price readings would have been unthinkable. At the time, double-digit inflation expectations were embedded in every day American economic life, as symbolized by the collapse of the U.S. dollar and the skyrocketing advance of gold, commodity and related hard-asset prices.
Then, as Paul Volcker and his successor Alan Greenspan gradually and continuously restrained money creation by the Fed, inflation anticipations were finally reversed. But now the question is, have policymakers unwittingly launched a new era of deflationary concerns?
Supply-siders like myself believe that it must pay adequately, after-tax, to work and invest more. Given what has happened to the stock market in recent years, it will have to pay much more, after-tax, to induce substantial new investment. That is why the president's tax package makes sense. By significantly reducing taxes on dividends, income (including small-business income) and capital gains, the Bush plan will substantially lower the federal tax bite on capital -- which will go a long way toward boosting real investment returns in the economy.
But investment returns also depend on business pricing power and profits. While it would be futile to pursue a monetary policy that simplistically seeks to inflate business prices, it is nonetheless important to avoid profit-wrecking deflation.
During the early part of 2002, the Federal Reserve loosened up quite a bit in an attempt to aid an economy that was still reeling from the events of 9-11. By temporarily decontrolling its policy of targeting the overnight interest rate, it opened the door to massive money-adding operations that contributed to 4 percent GDP growth and an S&P 500 that hit 1,150. That's just what we need to happen now.
In order to blunt business worries over the threat of long-run price declines, and to open wide the door to steadier prices, production, profits and investment returns, the Fed should take out an insurance policy by stepping up its money-adding operations. Today. The central bank should let the market determine interest rates. Then Greenspan & Co. should add new cash to the economy until prices and market rates tell us that deflationary expectations have been eradicated.