Inflation and the Reserve System

F. SCHNEIDER, JR.

REVIVAL in America's domestic business hasnow reached a stage at which keen observers feel that prosperitymay be had for the taking and are only worried as to whether the upswing is likely to develop into dangerous inflation. Agreement is general that business is good, that it is getting better, and that profit making ability is becoming the rule rather than the exception. Instead of wondering whether 1923 will witness a relapse to dulness and indifferent profits, economists and business men arc asking whether the vigorous revival will grow into a sound prosperity or degenerate into an unhealthy boom. Taking the commodity price level of 1913 as 100, the Department of Labor's index of wholesale prices rose during last year from 138 to 156. With further advances generally expected, the question is whether the movement will be a moderate one, ending with the general level in the neighborhood of say 165, or whether it will turn into a runaway affair with prices mounting to something like 200.

Unfortunately the stage is set in a number of ways so as to favor an inflationary movement. The supply of labor is short and existing restrictions on immigration prevent any material relief from abroad. Bidding for labor already has become a disturbing element and the tendency may well be accentuated as the revival progresses. In addition, the tariff is likely to act as a lever under prices, while surplus stocks of such commodities as cotton, wool and copper have been, or are being, exhausted.

ONE other important factor favors the continuation of the upward swing in prices. This is the plentiful supply of money at low rates and the demand in certain strong quarters for the maintenance of cheap money. So far the revival in business has made relatively little demand on the reserve banking power of the country. Acceleration of the turnover of goods and the withdrawal of funds temporarily placed in securities have taken care of increased production and prices. Our enormous gold imports of the past two years have swollen our cash reserves. Meanwhile the Federal Reserve banks maintain rediscount rates which are below those prevailing in the open market, radicals call for government credits and easy money, and the Administration seems committed to a policy of cheapness. It is clear, therefore, that the demand for goods is strong, that supplies of goods are of moderate proportions, that ample credit resources are available, and that the upward movement in prices is under way. The makings of inflation assuredly are at hand.

What now can be placed in oppositon to these forces? Is the inflationary movement certain? Time alone can furnish a sure answer; certain grounds for doubts do, however, exist. It is pointed out in some quarters, for example, that the full effect of the rebound in prices from the over-deflation of 1912 already has been felt. Others emphasize the fact that a large proportion of last year's upward movement was due to the strikes of the coal miners and railroad shopmen. With an agreement on soft coal miners' wages reached and with no reductions in the wages of railroad labor imminent, these observers claim that the worst is past and even regard some lowering in the price of coal as possible. They also point to the settlement of last year's long drawn out textile strike and express the belief that both labor and capital have been chastened and that a reasonable amount of forebearance will be in effect during the coming year.

LOOKING ahead to next autumn, the new crop situation will have an important influence. Cotton crops are particularly difficult to estimate because of uncertainty regarding the ravages of the boll weevil. It seems reasonable to assume, however, that the south will attempt to raise a large crop, and it is entirely possible that measures against the weevil will gain in effectiveness. Existing cotton prices are, furthermore, extremely high and while further advances on the present crop are possible, any long maintenance of a materially higher level seems doubtful. A larger output of wool meanwhile seems likely, since there are now one million more sheep in the country than a year ago, and, incidentally, seven million more hogs.

Among other factors tending to prevent a runaway rise in prices are the restricted though improved purchasing power of our agricultural districts and the unsatisfactory political and economic situation in Europe. British financiers expect at best only a moderate improvement in European trade this year, and the demoral ization which centers around Germany is certain to restrain buying of America's products.

From what has gone before it must be apparent that certain natural checks come into play after prices have advanced materially. One of these checks, the working of which is somewhat obscured by existing abnormalities in the currency systems of Europe, is the international movement of gold. When prices rise in one of two countries which are on a gold basis, the natural effect is to check exports from that country and to encourage imports by it. The result is an excess of imports by the country with higher prices and an outward movement of gold. Loss of gold in turn tends to curb the rise in prices.

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With Europe off the gold basis and with most of her exchanges seriously depredated, the export of gold by this country seems, at first glance, hard to visualize, If commodity prices here and abroad are reduced to a gold basis by allowing for the depreciation in exchange, however, an interesting fact develops. While gold prices for commodities have been rising here, they have been falling or stationary in Europe. As a result, the price of sterling exchange rallied last year from S4.17 to 84.64, the depreciation of the pound dropping, in other words, from 14 per cent to 5 per cent. Obviously it would not take a great deal more of the same sort of thing to bring sterling to par and to check the flow of gold in this direction, or even to reverse the flow.

AN attempt to strike a balance between the forces favoring and opposing inflation manifestly is a task of extreme difficulty. The best that can be done is to assign approximate weights and guess the result. If, on the one hand, the supply of labor is short, it seems probable that the lessons of the past year are close enough to foster a reasonable spirit on the part of both employers and employes; that is, unless the ccst of living turns up sharply. Supplies of goods have been, it is true, reduced; but they are now in the way of being replenished. As for the tariff, it may, perhaps, lift prices further, hut its ultimate effect may be to restrict our exports and so hasten the recovery of the foreign exchanges. Meanwhile the llow of gold in this direction is slackening and any large advance in prices here would be likely to check or reverse the movement. Furthermore, with pure hasing power in the agricultural districts still below normal and with that of Europe seriously impaired, the chances of a general boom are diminished.

Probably the decisive factor in the raatter will be the degree of self-control exercised by the country as a whole. If business men will be satisfied with moderate profits and will refrain from speculation, if labor will be content with existing good wages, and if the public at large abstains from extravagance, the situation seems safe. Fortunately, rccollections of the sufferings which followed the boom of 1919-1920 are still fresh and there exists a desire both to avoid a repetition of those experiences and to make the period of prosperity last as long as possible.

NATIONAL self-control will be the more important during the coming months because the money and banking situations are in some respects peculiarly unpleasant, We have come to assume that the Federal Reserve system has removed all our banking troubles—that it is a sure bulwark against crises and that it is an effective regulatory influence in money and business. That the system does mobilize the country's reserves and provide an elastic currency is not to be doubted.. Nor are the useful services it performs, such as in arranging for the instant telegraphic transfer of funds and in facilitating the huge government financial operations which center around the tax dates and include the redemption and flotation of Treasury certificates, to be minimized. Many persons assume, however, that our Federal Reserve system provides a central bank comparable to the Bank of England—one that exercises a fairly.constant influence on the money market and that can be relied on to curb dangerous tendencies and anticipate troubles. Actually, the Federal Reserve system falls considerably short of this ideal.

The explanation for this regrettable state of affairs lies partly in the difference between the banking institutions of the two countries and partly in the injection of politics into the management of our own system. England is a small, thicklysettled, homogeneous country whose population is occupied principally with industry and commerce and little with agriculture. The type of credit employed is fairly uniform. It is of the short-term, self-liquidating variety, and it is handled by a system of banks which through successive amalgamations has come to represent the last word in branch banking, In this far-flung country, on the other hand, agriculture, with its longer-term credits and greater uncertainties, makes up a large proportion of our business, conditions in different regions are extremely diverse, and the banking system is composed of thousands upon thousands of independent banks, ranging from big metrojxflitan institutions down to diminutive country "banklets". Most of the lending in this country is done, furthermore, on single-name paper and on loans on open account. With our many different kinds of paper and wide variations of rates as between different localities, control by a central bank with a single discount rate is something not easy of achievement,

LET us consider for a moment what happens in England when speculation is carrying things with too high a hand, or a sharp rise in prices is threatening to exhaust credit resources. The Bank of England, which always maintains its discount rate slightly above the market rate, advances its charge for accommodation. Open market rates respond and a brake is applied to the inflationary tendency. In addition, the Bank of England exerts control over rates by its ability to enter the market and buy or sell hills in the same manner as a private bank.

Our own Federal Reserve system is at a disadvantage in both of these particulars. Its ability to buy paper in the open market is limited to acceptances, and while an attempt has been made to build up a market for the latter, the total amount outstanding is relatively small, In addition, the reserve banks have been sluggish in making use of this medium to influence open market conditions,

WITH regard to the other regulatory instrument of the reserve banks, the rediscount rate, the difficulty with reference to the diversity in local conditions already has been noted. Admitting this does not, however, explain the fact that the official rates are below, rather than above, those in the open market, This abnormal relationship arose during the war in connection with efforts to float the Liberty loans; but its continuation at the present juncture is hard to excuse. Instead of having the rate structure of our central banking system arranged so that its reserves are protected and are made available in times of emergency at a penalty, we have a situation which makes rediscounting profitable and so encourages lavish distribution of credit and speculation, The plain fact is that politics have got into the Federal Reserve system. The present Administration actually has claimed credit for reducing Federal Reserve rates, although proper theory calls for an autonomous board and autonomous reserve banks, which shall decide such matters scientifically and without regard to popular clamor or political pressure. President Harding's failure to reappoint Governor Harding and his long delay in filling vacancies, taken with the concessions made to the farm bloc, have seriously weakened the Board's personnel and prestige. The advocates of cheap money appear to hold the upper hand, and there are grounds for serious doubts as to whether the proper degree of resolution and courage will be shown in advancing official rates as the upward movement continues.

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As now operated, the Federal Reserve system will not become an effective agent until the very last stages of a boom are reached; that is, until most of the damage has been done. Incidentally, the system will become an influence just in time to receive theblameforthe inevitable deflation. Obviously the situation has highly unpleasant implications. It is by no means sure that inflation will come, but it is something for thoughtful citizens to ponder over, that our logical defense against unhealthy booms and consequent depressions has been seriously weakened by a policy of political expediency.

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