Fed tinkering could spark inflationary spiral

Based on its recent actions, the Fed is clearly spooked by the weakness in capital spending and the lack of "visibility" that many capital-goods producers have with respect to the timing of a rebound. Quite correctly, the Fed links increased capital spending with increased prospects for profitability. Apparently this is why Fed staff members periodically ring up the First Call equity research service to check on the profit projections of America's best and brightest - Wall Street stock analysts. So, in part, the Fed's rate-cut program is designed to boost corporate profitability, or expectations of such, which, in turn, will boost capital spending.

Of course, one factor that has contributed to the slump in corporate profitability and capital spending is that the high-tech bubble that the Fed fueled in 1997 and 1998 has burst after the Fed cut back its easy-credit rations to the economy starting in mid-1999. However, another factor has to do with a by-product of the Fed's previous easy-credit policies - rising production costs.

The Fed's previous easy-credit policies stoked up the demand for all goods and services, including energy goods and services. But while investment in high-tech boomed, investment in more mundane things like energy exploration and distribution was neglected. As a result, the demand for energy is now outstripping its supply. The rise in energy prices is cutting into corporate profits - corporate profits in the non-energy sector of the economy, that is. Profits are soaring for corporations involved in the production and distribution of energy. These energy-related corporations are likely to plow their increased profits into capital spending to enable them to find and distribute even more energy. But energy is so old-economy that the Fed doesn't take these profits and capital spending into consideration when it cuts the funds rate.

How does the Fed increase the profit prospects for non-energy corporations faced by rising energy costs? By cutting interest rates, which, all else the same, ramps up money supply growth, which ramps up the demand for all goods and services, including energy. If all goes according to plan, the selling prices of non-energy goods and services will rise sufficiently so that revenues will increase faster than energy costs, thereby improving the profits of the producers in the non-energy sectors. Of course, the plan could go awry with energy costs continuing to rise faster than sales revenues in the non-energy sectors. Either way, though, we are looking at higher inflation.

It was reported last week that employee costs rose at an annualized rate of 4.5 percent in the first-quarter. First quarter productivity data are not yet available, but it is a good bet that nonfarm productivity did not grow faster than the fourth quarter's 2.2 percent. Thus, as is the case with energy costs, labor costs are cutting more into corporate profit growth than in recent years. What's the Fed to do? When in doubt, print (money) - that's the Greenspan motto. With luck, faster money supply growth will create sufficient demand for corporations to pass on their higher labor costs in the form of selling prices. Of course, this increased final demand will increase the derived demand for labor, thus pushing up labor costs more. But given the lags in the adjustment of labor costs to final demand, corporate profits will still go up - temporarily. After labor costs have adjusted upward, the Fed will have to rev up the printing presses more to keep profit growth up.

In sum, the Fed, with its new goal of boosting corporate profitability, appears to have embarked on a policy that will result in a wage-price spiral. A number of prominent Austrian economists believe that too-rapid money growth got us into the economic mess we're in today by creating an investment bubble.

If too-rapid money growth was the cause of our current economic malady - a thesis that is open to much debate - how could another dose of it be the cure? Put another way, if money created by central banks resulted in the creation of real wealth, then all of the world's economic problems would be solved because central banks can create money at nearly a zero cost in terms of real resources used.