Anthony Mirhaydari: Hiking inflation won't help, Ben

Extra11/3/2010 6:58 PM ET

Hiking inflation won't help, Ben

Continued from page 2

It's about structure

The justification for a huge amount of QE was recently taken up by economists at Goldman Sachs. The key is how much excess capacity -- including empty factories, unused machinery, unemployed workers -- there is in the economy. The Fed would inject money to try to get that excess capacity back to work.

By one common measure of the "output gap," the Goldman Sachs team estimated the Fed could potentially justify injecting an additional $4 trillion into the economy as part of its QE2 allocation.

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But because of the rise in the so-called "natural" unemployment rate -- which is the minimum unemployment rate the economy can support without seeing wage inflation -- the output gap is actually much smaller than that measure would show. (I discussed this issue in a column back in August. )

In fact, Athanasios Orphanides, a senior adviser to the Fed and the governor of the Central Bank of Cyprus, finds that a key error (.pdf file) by policymakers during the Great Inflation era was not properly accounting for the rise in the natural rate of unemployment. By this he means too much stimulus was injected in the economy to try to stir employment, and that stimulus led to inflation.

The same mistake is being made now. Estimates vary, but a recent update (.pdf file) by Federal Reserve researchers put the natural rate of unemployment as high as 8.6%. If true, then the economy is running only 1.8% beneath its potential output -- not nearly enough to justify a large QE program.

John B. Taylor of Stanford, the creator of the "Taylor Rule" formula for monetary policy used in the Goldman Sachs analysis, crunched the numbers himself and found conditions justify a Fed lending rate of 0.75% instead of the current rate of 0.2%. That's right. Taking into account the structural friction in the economy, the Fed should be mopping up all its extra dollars and raising interest rates.

Instead, Bernanke is doing the opposite. And his mistake puts us all at risk.

Anthony Mirhaydari: Hiking inflation won't help, Ben

To give you an idea of the magnitude of the problem, Meltzer finds that the Great Inflation was driven by excess money creation -- the money supply was growing faster than the economy. The effect of this is to make money worth less in real dollars. You can see in the chart above how excess monetary growth peaked around 10% in 1974 and again in 1980, before moving lower.

Right now, excess monetary growth has been above 10% since the fourth quarter of 2008, and it spent three quarters above 100% during the Fed's QE1 initiative. QE2 should result in a similar boost -- and that's downright scary.

Remember the words of the great monetarist Milton Friedman, a hero of Ben Bernanke: "Inflation is always and everywhere a monetary phenomenon."

Be sure to check out Anthony Mirhaydari's new investment advisory service, the Edge. A free trial has been extended to MSN Money readers. Log in using the following credentials. Username: "freeuser" Password: "edge"

The author can be contacted at anthony.mirhaydari@live.com. Feel free to comment below.

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