How the Fed accelerated the inflation it is now confronting

From today's WSJ:

The nearby chart from economist Arthur Laffer offers an instructive summary of recent monetary history. It compares actual prices, as measured by spot commodity prices, to the fed funds rate, which is a rough proxy for tighter or looser monetary policy. The left side of the chart records the great inflation of the late 1970s and the Fed's attempts to break it. The right side shows what we've been living through this decade, with soaring commodity prices amid historically low interest rates.

We've been writing since at least 2003 that the two are related, and worrisome. In June 2003, the Fed cut its target fed funds rate to an extraordinarily low 1% and kept it there for a year. Even when it began to tighten again, the Fed did so very gradually, causing us to write in June 2004 that "the danger with gradualism" is that "it risks always being behind the inflation curve."

There was no inflation evident at the time, but monetary policy works with a lag and it showed up later -- most notably in the housing asset inflation of 2004 and 2005. Everybody loved that bubble while it lasted, including some lenders who found increasingly creative ways to lend to increasingly unreliable borrowers. We are now living with the aftermath of that mistake, however, amid the current housing washout that has lasted a year already, and with probably more financial casualties to come.

Neither former Fed Chairman Alan Greenspan nor successor Ben Bernanke has acknowledged the Fed's role in creating this housing bubble. But last autumn Richard Fisher, president of the Dallas Fed, offered a kind of proxy mea culpa when he noted that "In retrospect, the real fed funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been."