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THE ROAD TO HYPERINFLATION, Part 3
By Henry C K Liu
Taylor rule simulations suggest that the Fed should perhaps have been thinking
of itself as one important cause of that phenomenon in the first place.
The mystery of neutral interest rates
Journalist Greg Ip of the Wall Street Journal reported on December 5, 2005 that
in a written response to a letter from Rep Jim Saxton (R- NJ), chairman of the
Joint Economic Committee of Congress, about the meaning of a neutral interest
rate as invoked by Fed chairman Greenspanís testimony, Greenspan said that
definitions of "neutral" vary, as do methods of calculating them and that
neutral levels change with economic conditions.
Thus the concept of a neutral rate is made useless by practical
difficulties. This of course was a standard Greenspan position of all economic
concepts as the wizard of bubbleland always drove by the seat of his pants,
doing the opposite of his obscure official pronouncements. With the Fed widely
expected to raise the Fed funds rate target to 4.25% the following week in a
continuation of the traditional policy of "measured pace", up from its low of
1% in June 2004, and with the 10-year yield at 4.5%, the yield curve was
approaching flat and an inversion soon if the Fed, as expected, continued its
interest rate raising policy. Historically, a flat yield curve signals future
slow growth and an inverse yield curve signals future recession.
But Greenpsan, invoking rational expectations theory, dismissed the historical
pattern by arguing that lenders were likely to accept low long-term rates
because of their expectation of future low inflation, and this would stimulate
future economic activities. So stop worrying about the inverse yield curve. It
was an attitude that continued when an inverse yield curve emerged again in the
There is no denying that the US economy, as well as the global economy, had
been plagued with persistent overcapacity. And if low inflation, as defined by
the Fed, is the result of slow wage increases, where in the world can the
future expansion of demand come from? Many analysts, particularly in the bond
markets, have sharply criticized the Fed for keeping interest rates too low for
too long and ignoring signs of incipient and insipid inflation.
In his Monday, December 5, 2005 Congressional testimony, Greenspan reiterated
his view that recent price increases were mainly a result of "transitory
factors", such as rising oil prices. True to his Keynesian past, Greenspan also
pointed out that corporate profit had been so high that businesses had ample
room to offer higher wages without raising prices to consumers. But of course,
supply-side economics requires corporate profits to boost return on capital
rather than boost demand by raising wages. And management never voluntarily
raises wages without being pressured to by labor strikes, let alone for the
good of the economy. To management, the only thing good for the economy is
The surprisingly tentative tone of Greenspanís residual Keynesian outlook
contrasted with the more extended attempt in his testimony on the following
Tuesday to buttress his view that core inflation, which excludes volatile areas
like food and energy prices, was likely to remain below 2% through the end of
the next year. But despite his optimism about inflation remaining under wraps,
Greenspan cautioned investors against thinking that the Fed might feel less
constrained in unwinding its cheap-money policies of the past three years from
2001 to 2004.
In the June 30, 2004 Congressional hearing, Greenspan carefully dodged an
opening question from Senator Richard C Shelby, Republican of Alabama and the
chairman of the Senate Banking Committee, on whether the Fed would raise the
federal funds rate another quarter-point at its August 2004 meeting. Greenspan
also refused to be pinned down on what was in many ways the most basic
question: What constituted a "neutral" interest rate that Greenspan claimed he
tried to follow that neither provoked inflation nor slowed down the economy?
Many economists have suggested that a neutral fed funds rate - the rate charged
on overnight loans between banks and the key policy tool the Fed relies on to
guide the economy - is between 4% and 5%. That would have been a big increase
from the June 30, 2004 fed funds rate level of 1.25%.
Like the famous description of pornography from Supreme Court Justice Potter
Stewart, Greenspan said people would know the rate when it arrived. "You can
tell whether you're below or above, but until you're there, you're not quite
sure you are there," he said. "And we know at this stage, at one and a quarter
percent federal funds rate, that we are below neutral. When we arrive at
neutral, we will know it."
Economists have highlighted numerous difficulties in estimating the neutral
federal funds rate in real time, including data and model uncertainty, which
can result in estimates that are off by a couple of percentage points. These
difficulties add to the challenge of conducting monetary policy, especially
when the fed funds target is near the neutral rate, because policymakers must
make their decisions without the benefit of reliable data. Therefore,
policymakers will be especially attentive at this stage to incoming data. And,
until research finds a solution to the difficulties of estimating the neutral
rate, the conduct of policy will remain both a science and an art.
Expectations undermine inflation targeting
The problem is that according to "rational expectations" theory, market
expectations can undermine the Fedís inflation targeting policy to push
tolerance for inflation increasingly higher until it reaches hyperinflation.
Inflation targeting advocates therefore argue that inflation targeting should
encompass a dual objective of holding down inflation as well as preventing
The financial press, grasping at straws in the wind to anticipate Fed policy,
highlighted Fed chairman Bernankeís January 10, 2008 speech at the Women in
Housing and Finance and Exchequer Club Joint Luncheon in Washington, DC, on
financial markets, the economic outlook, and monetary policy, as signal of the
Fed standing "ready to take substantive additional action as needed to support
growth and to provide adequate insurance against downside risks".
Yet Bernanke also said: "Any tendency of inflation expectations to become
unmoored or for the Fedís inflation-fighting credibility to be eroded could
greatly complicate the task of sustaining price stability and reduce the
central bankís policy flexibility to counter shortfalls in growth in the
future. Accordingly, in the months ahead we will be closely monitoring the
inflation situation, particularly as regards to inflation expectations."
Thus the Fed is restrained in its interest rate action not only by actual
incoming inflation data but also by data on inflation expectations. This means
that when the market expects the Fed to cut interest rates, it actually limits
the ability of the Fed to cut rates.
After the Fedís January 2008 unprecedented and drastic interest rate cuts, the
market has been anticipating that the European Central Bank (ECB) would need to
follow the Fedís lead to lower euro rates significantly. Yet while the ECB
faces a similar dilemma as the Fed with regard to simultaneous vigorous
inflation and slowing growth, the ECB is limited by its singular mandate of
restraining inflation, unlike the Fedís dual mandate of price stability and
support for growth and employment. Jean-Claude Trichet, head of the ECB,
testified in front of the European Parliament that inflation remains the ECBís
prime focus to "solidly anchor inflation expectations".
The euro zone economies are saddled with a less flexible structure of wage
volatility that cannot adjust quickly to price changes as in the US because
most European wage contracts are indexed to inflation but not to deflation.
Unlike their US counterparts, European companies cannot layoff workers as
easily, or adopt a two-tier wage and benefit regime for new workers.
Market expectation is focused on the inevitability of a euro-zone slowdown from
the financial market turmoil that had originated from the US in August 2007 and
on the prospect of euro interest rate reduction in the face of asset price
correction despite a strong euro against the dollar. Yet European politics will
not allow political leaders to be complacent about a strong euro buoyant by a
flight from a deteriorating dollar while euro economies face a decline from
global depression caused by a slowdown in the US economy. In the current global
trade regime, the depreciation of the dollar will bring down the value of all
other currencies. Exchange rate fluctuations only reflect temporary
differentials in the rate of decline in the purchasing power of different
currencies. Even as the euro falls against the dollar, it continues to lose
real purchasing power.
Democrat Congress wants employment targeting
As early as February 19, 2007, half a year before the August emergence of the
credit crisis, Representative Barney Frank of the 4th Congressional District of
Massachusetts, the Democratic chairman of the House Financial Services
Committee, told The Financial Times it would be a "terrible mistake" for the
Fed to adopt inflation targeting to guide its interest rate decisions. Frank,
whose committee is the House counterpart of the Senate committee charged with
oversight of the US central bank, said such targeting "would come at the
expense of equal consideration of the [the Fedís] other main goal, that is
By that Frank meant inflation targeting could be used to keep inflation down at
the expense of full employment. His comments came as Fed policymakers entered
the final stages of a far-reaching strategy review that included detailed
debate over the merits of adopting an inflation target. What Frank opposed was
the prospect that the Fed would fight inflation by keeping interest rate above
that needed to produce low unemployment.
Fed chairman Bernanke believes that the central bank would be better off with a
relatively flexible inflation target - one that would be achieved on average,
rather than within a specific time frame, giving maximum latitude to respond to
exogenous output shocks. Critics point out that this could lead to the Fed
alternatively overshooting and undershooting in the short term, creating
undesirable volatility in the market. This is because incoming economic data
are known to be unreliable and need subsequent revision.
Further, in order to make any such policy change, Bernanke would need at least
the tacit consent of key figures in Congress. Frankís unequivocal statements
against inflation targeting as it impacts even short-term unemployment suggest
this consent will still be difficult to secure even after generally favorable
congressional hearings. Frank told The Financial Times that Bernanke "has a
statutory mandate for stable prices and low unemployment. If you target one of
them, and not the other, it seems to me that will inevitably be favored". The
reality could be that neither stable prices nor low unemployment can be
achieved by short-term flexible inflation targeting.
Advocates of an inflation target at the Fed say it is important to distinguish
between the relatively rigid form of targeting as used by the Bank of England
and the relatively flexible form favored by Bernanke. Frank, however, said he
would not support even a flexible target "without equal attention to
unemployment also". What Frank wants is a low unemployment target to link to a
low inflation target. The fear is stagflation with high unemployment
accompanied by high inflation.
Inflation expectation around the world
Inflation expectation has been rising everywhere in the world, driven in part
by rational expectation on the part of market participants. Beyond price data
on oil and food, US core inflation in the 2.2 - 2.3% range since April 2006 has
been above the central bankís stated comfort level of 1.6% to 1.9% for some
time. Further, the "core rate" is designed to sooth the financial markets and
to distract market participants from the reality of rising inflation. The core
rate does not exist anywhere in the real economy. It is a fictional notion
designed to disguise inflation to justify perpetual real negative interest
rates. And negative real interest rates have an upward spiral effect on
And in the euro-zone, even a rising euro has not stopped inflation from rising
to 3% in November 2007, largely due to rising price of dollar-denominated
imports, such as oil, outpacing the rise in exchange value of the euro.
Evidence of second-round inflationary effects are already visible, with
Europeans workers, most vocal in France and Germany, demanding wage increases
to compensate for a loss of purchasing power beyond the acceptable range of
accepted inflation and productivity targets. Members of the British police held
a mass protest over pay in central London on January 23, 2008, angered by a
2.5% pay rise being backdated to only December 1, 2007 for member officers in
England, Wales and Northern Ireland.
Long-term inflation expectations in the euro-zone, as expressed by interest
rate futures, are running at nearly 2.5%, a robust 25 basis points above
official ECB target of "close to but below 2%". Forecasters expect euro-zone
inflation to slow in 2008 but nobody is predicting that it will fall below
target, let alone turn negative for the rest of the year, particularly if the
dollar continues to decline in purchasing power. Responding to a declining
dollar, oil and other key commodities prices denominated in dollars can be
expected to rise in adjustment, causing inflationary pressure worldwide.