Friday, June 05, 2009

Why The Fed Can't Make The Problems Go Away

The party line is that we shouldn't worry about inflation, because right now the immediate concern is the risk of a deflationary depression. We must use all available means to prevent that and err on the side of inflation because the Fed could always reverse course if inflation really resurfaces and becomes a problem.

Given how the rapid increase in money suply has now finally begun to manifest itself in rising commodity prices and increased inflationary expectations, as well as signs that the pace of contraction is receding, we are quickly approaching the point where this will be tested in practice.

The behavior of central bankers is difficult to predict, but given the popularity of another idea it is unlikely that they will really reverse course soon enough. And perhaps even more importantly, if they do, we will see a quick return into an economic slump.

Remember, this line of thinking was also popular during the brief 2002-03 deflation scare, where Alan Greenspan, Ben Bernanke and other Fed officials worried about deflation. This caused them to lower short term rates to 1%, to eliminate the risk of deflation. If, as they hoped, this was successful, they would normalize rates. But they also realized that a quick reversal would create disruptions, so when they finally started to tighten again they deliberately tightened in a "measured" pace. But while that did create less short-term disruptions, it also ensured that the imbalances of the boom would continue to grow and so get worse for an even longer time. Eventually, a great interest rate shock was needed to prevent inflation-something which triggered the crisis. The "don't worry about it, we'll deal with it later"-approach failed as the problem simply grew bigger because it was dealt with later rather than sooner. But for many prominent pundits , the problem was that the Fed raised rates too much and thus created problems for all of those home buyers who had based their decisions on the previous very low rates.

Another similar example was the 1937-38 downturn which Paul Krugman and other Keynesians blame on fiscal and monetary tightening. Even though it happened several years after growth resumed, that was apparently to soon. If four years into the boom is considered too hasty, that means that fiscal and monetary tightening according to them shouldn't be implemented until 2014 at earliest. That's a lot of time for inflation to develop.

Given the widespread view that the inflationery policies should continue several years into the boom, it seems likely that the Fed will in fact do so.

Suppose however that the the less likely but definitely possible scenario that the more hawkish elements within the Fed manages to implement measures to limit inflation really materializes, what then? Well, then we will see another slump.

Inflationary booms are created on the basis of an unsustainable source of fundings, money creation. Once that is removed however, the boom will turn into a bust. Meaning that if Bernanke manages to create another bubble, that will turn into another bust as soon as they feel compelled to remove that basis. If that happens, then Krugman and his sympathisers will no doubt present this as a repeat of the 1937 slump caused by "premature" policy tightening.

Either way though, the outlook is not good.


Blogger Jozef Rudy said...

Stefan, don´t you think that the rise in interest rates (not caused by FED but by demand and supply) might prevent the recovery and thus inflation?
It seems that the rise in interest rates recently has been strong and part caused by inflation scare? or the hopes in possible recovery. This also is confirmed by recent weakness of the dollar and claims by various authorities (china, brazil) for world currency.
Anyway, although FED might not be of an opinion to raise the rates, 2-year interest rates rose 0.5% in last 2 days.

I might be wrong, but that might not have happened before (in previous periods) because now there is another factor, slowly spreading fear to hold dollars?

10:58 AM  

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