Sunday, June 15, 2008

Will Fed Dare Raise Interest Rates?

In the most recent week, both the dollar and U.S. market interest rates have started to rise again. The reason for this recovery is increasing speculations that the Fed might not only stop cutting interest rates, but might soon raise them again. Given the facts mentioned in the previous post, there can be little question that the Fed should do this.

However, more interesting than the question of whether they should do it is the question of whether they are likely to do it. Central bank action tends to be relatively unpredictable, compared to the effects of central bank actions once implemented, but I will still speculate about it.

It seems clear that some Fed officials, most notably Philadelphia Fed chief Charles Plosser wants to raise interest rates, as they correctly identify the very strong inflationary pressures. And while most other Fed officials are a lot less hawkish than Plosser, most recognize that inflation is indeed a big problem.

However, just because they view price inflation as a problem doesn't necessarily mean that they'll actually do something about it. The reason for that is first of all that the economy will likely continue to contract, especially after the temporary boost from the so-called tax rebates is removed. And with growth negative and unemployment rising, raising interest rates will create very negative political reactions, especially in the emerging Democratic supermajority.

The second reason is that raising interest rates would likely again flatten the yield curve, which in turn would hurt the many weak financial institutions. Of course, a quarter point hike wouldn't do much difference in that respect, but then again a quarter point hike wouldn't do much difference in terms of containing inflation either.

The only way the Fed could rein in inflation in a meaningful way would be to do another Volcker and raise interest rates so high that the economy falls into a very deep downturn. This downturn would likely be even greater than in 1981-82 because the level of debt is much higher and the financial institutions much more fragile. Faced with the choice of higher inflation and long term decline on the one hand and a painful short term purge of inflationary excesses on the one hand, the Fed seems more likely to choose the former.

It is still possible, but very far from certain, that the Fed might raise a quarter point or two later this year. However, even if they do, such modest moves from the current ultra-loose stance will not prevent inflation from getting worse.

UPDATE: Bob Novak, known for his Washington D.C. connections says the Fed will likely not raise interest rates.

2 Comments:

Anonymous Carlton said...

I read your BLOG every day now and find it very educational, so thank you for it.

I seem to recall you have said monetary inflation takes between one and two years to feed into prices (except for very elastic things, like oil).

Therefore the price increases we see in the US marketplace would be from last years monetary creation. All other things being equal (specific changes in supply and demand).

So as M3 has continued to grow in the last twelve months anything the Fed does won't be seen on the monetary side for 12 months or more.

But what about the relationship of the dollar?

Given the USD is a reserve dollar, if they strengthen it then will commodity prices stablise - or is this inextricably linked to M3?

Do you see oil prices primarily as a function of US monetary policy. I mean we haven't had a supply side shock that would drive prices like this have we?

Any comment would be appreciated to clarify my thinking.

3:37 AM  
Blogger stefankarlsson said...

Carlton, it is nice that you appreciate my blog and visit it. As for your questions, first of all, as I noted in the post you seem to refer to, the effect on money supply from monetary policy actions are almost immediate.

As for the effect of monetary policy on price inflation, it is correct that I think most of the effect will come with a significant time lag of at least -and often more than- 12 months. And that does indeed imply that most of today's price inflation is the result of past money supply increases.

However, as the effect is more immediate on prices like oil some of the current inflation is the result of the aggressive loosening since August last year. That doesn't mean that I think monetary policy is the only factor driving the oil price, but is an important one in the short-term.

This effect doesn't just come via the exchange rate effect, as this would imply that in a hypothetical world with a global central bank and global monetary union, monetary policy wouldn't have a disproportionate effect. It would still have that effect because the price of oil is more flexible than most other prices and so would respond faster to an increase in the money supply.

That also implies that the money supply increases of the Fed and other central banks have contributed to pushing up the oil price more than just through the exchange rate effect. This in turn implies that monetary policy could continue to push up oil prices even if the dollar stabilizes, although of course the effect will be smaller than if the dollar weakens.

I hope that clarified your thinking.

8:36 AM  

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