The Fed and the stagflation
specter By Hossein Askari and
Noureddine Krichene
Recent economic
indicators are frightening and raise serious
concerns about the world economy in a globalizing
world. Since August 2007, the US dollar has
depreciated to 1.55 per euro from 1.37; oil prices
have jumped to US$110 per barrel from $65, to
translate into higher prices of final goods and
services; gold prices, though now receding, jumped
to $1,000 from $670, and most other commodities
and food prices have risen around the globe at
rates unprecedented in recent history.
Simultaneous with these developments, a
credit crisis has cast an ominous shadow on global
finance. These developments have severe
implications for governments, businesses and
individuals around the world. The underlying
factor behind these developments has been lax
monetary policy - and the
resulting
rapid
inflation in real estate prices and all goods and
services - and lax supervision of the financial
sector.
Inflation is defined as a high
rate of price increase and fast depreciation of
money. For households and wage earners, it means
growing impoverishment as less food and other
necessities are affordable. Inflation imposes a
heavy tax on cash balances that are held by
businesses and individuals; incomes are eroded;
and most financial assets lose real purchasing
power. People with fixed income and pensions
are penalized severely as the cost of living
rises. Inflation entails a tremendous
redistribution of wealth in favor of debtors at
the expense of savors and creditors, erosion of
financial savings, and considerable loss in social
welfare. As inflation gains speed, fewer goods get
to markets and suppliers make higher turnover with
fewer goods sold. Inflation destroys
competitiveness, lowers productivity, creates
relative price distortions, and increases
transactions costs. If workers become disenchanted
and demand wages increases to compensate for the
loss of purchasing power, inflation will become a
spiraling phenomenon.
How did the world
and in particular the US economy reach this
inflationary stage and perhaps the end of three
decades of prosperity?
By far the main
root cause is the Fed's excessive expansionary
monetary policy since 2000. The danger for the Fed
is always that it may fall under the influence of
politicians or be called to finance growing public
sector deficits (see eg, Milton Friedman, 1959,
A Program for Monetary Stability). For
these reasons, scholars such as Friedman
prescribed fixed rules for the conduct of monetary
policy against which the performance of Fed
policymakers can be assessed, and warned against
discretionary powers.
In the past seven
years, the Fed has defiantly followed an
aggressive expansionary policy, which consisted of
reducing interest rates to the lowest in the
post-war period, disregarding credit risks as
irresponsible mortgage lending fueled the housing
bubble, and ignoring the rapid depreciation of the
US dollar.
In a globalizing world, many
other major central banks followed the same
policy. Major key interest rates fell more or less
simultaneously, entailing huge worldwide expansion
of demand for goods and services and assets and
spectacular commodities inflation.
The
Fed's low interest rate policy reduced the cost of
deficit financing for the US government and
enabled it to finance growing fiscal deficits,
doubling the outstanding government debt over less
than six years. Housing prices rose at phenomenal
rate and so did oil, gold and other commodities
prices, while the dollar fell significantly in
value.
To keep interest rates low, the Fed
injected as much liquidity as required to
accommodate any demand for reserves by the banking
system and credit expansion. Money supply has
risen faster than real growth and commodities
supply. Since an increase in money supply has no
counterpart in terms of goods and services, the
more obvious effect of injecting money would be a
rise in prices. The consequences of a lax monetary
policy are not hard to predict.
The Fed
has been pursuing many objectives simultaneously:
restoring housing prices so owners will keep
thinking they are wealthy and continue to spend
lavishly, maintaining stock indexes on a rising
path, and preserving full employment; in the
process, the Fed was minimizing the negative
effects of inflationary pressures and risk of a
falling dollar.
It would appear that the
Fed is dominated by the conviction that it can
attain many objectives instantaneously and without
conflict by lowering interest rates and injecting
money. It responded hastily to downturns in the
stock market by promptly lowering rates and
injecting billions of dollars in liquidity without
due assessment of drawbacks of further loosening
of the monetary conditions.
Damage by the
Fed It would appear that the Fed has
not yet realized how damaging its actions since
August 2007 have been when it started to
aggressively lower interest rates. Pumping
billions in liquidity into the economy is only
pumping more paper money that has no real output
backing and will only add more pressure on prices.
The situation has only deteriorated
further. Had the Fed avoided such loosening
actions, the observed deterioration of financial
indicators might not have occurred. The Fed wanted
to achieve a miracle that no central bank or
government had yet achieved: achieving economic
growth with galloping inflation and deteriorating
financial conditions.
It is obvious by now
that lowering interest rates has set a vicious
circle of a depreciating dollar and higher energy
prices. While borrowing costs may be lowered, the
general increase in energy and input prices will
largely offset cost savings arising from lower
interest rates and increase overall production
costs for producers. It also reduces purchasing
power for households.
At the international
level, with the dollar rapidly losing its reserve
status, capital inflows to the US will diminish,
world trade will rely on other currencies only to
the extent these currencies remain stable in terms
of their purchasing power. If these currencies
lose in turn their purchasing power, countries,
including oil and commodities producers, will be
less inclined to accumulate depreciating
currencies and therefore will supply less oil and
non-oil commodities. This in turn will
considerably slow world trade and therefore
economic growth.
The solution to the
present inflation is not a novel one. Paul Volcker
had the courage and farsightedness to implement
the needed policies in the late 1970s and early
1980s. It consisted of strictly controlling the
growth of high-powered money and letting the
economy adjust to a sound and safe monetary
policy.
Controlling the money base is in
essence a basic principle of the quantity theory
of money and has long been prescribed by famous
economist such as the late Milton Friedman. Fiat
money, because it is almost costless to print,
should not become an instrument in the hands of
public powers who use it the way they want in
response to budget deficits, hiccups in the stock
market, or other purposes no matter how laudable
they could be.
Full employment is often
cited as an objective of monetary policy and
provides a reason for central banks to relax
monetary policy. But it is quite apparent from
accepted economic theory that the full employment
objective does not fall under the purview of
central banking.
What is required from a
central bank is a sound management of liquidity
and the banking system. Full employment is a
long-term objective of government development
strategies. Monetary policy can contribute to this
objective only to the extent it remains safe and
stable.
The basic principle in central
banking is for the monetary authorities to abide
by monetary orthodoxy and safety rules for the
protection of the value of money and enforce
regulatory and legislative regulations in the
supervision of the banking system.
Obligations of the central
bank Lawmakers should compel the
central bank to observe its obligations for safe
conduct of money policy. In pursuing this
objective, central banks should focus on
controlling money supply growth and adhering to
safe and sound credit policies.
With
stable money supply, the economy will be able to
make temporary adjustments to economic
fluctuations and external shocks. Central banks
should appreciate their limited role. Monetary
policy is not meant to be a quick fix to every
economic problem. If it were the case, poor
countries would only have to print money and grow
rapidly richer.
Only by strictly
controlling monetary aggregates and accepting a
temporary recession and adjustment can
policymakers contain the prevailing deteriorating
economic and financial situation. If not,
stagflation will be more damaging, protracted, and
enduring than the cost of temporary adjustment.
The monetary rule for targeting interest
rates is not a safe bet and is inherently known to
cause booms and busts. The safe conduct of
monetary policy is a priority objective and is a
prerequisite for sustained growth, employment and
prosperity. There is no other alternative to
choking off inflation and voiding its dynamics
except through reducing the money base; the
quicker and stronger the central bank's reduction
of money supply, the shorter the economic
recession will be and the faster the economy will
return to a stable long-term economic path.
Continuing the present stance will
aggravate the crisis; it has become a vicious
circle of lower interest rates, a falling dollar,
racing oil, gold, food and commodities prices,
accelerating inflationary pressures and worsening
economic growth prospects.
At the same
time and simultaneously, the Fed and other
regulators in the US should admit that the present
crisis was not brought about by high interest
rates and thus it will not disappear by reducing
interest rates. Exploding credit deterioration has
been the other blade of the scissors that has
severed the normal functioning of financial
markets.
Regulators must shore up the
segments of the market that are suffering not
because of excesses but because of the general
fear prevailing in the market; this includes the
municipal bond market, which is largely safe but
may be damaged if regulators do not step in to
provide needed guarantees.
In sum, prudent
monetary policy supported by selective federal
guarantees and programs are the medicine that the
federal authorities should administer to the
markets now before more damage is done.
Hossein Askari is
professor of international business and
international affairs at George Washington
University. Noureddine Krichene
is an economist at the International Monetary Fund
and a former advisor, Islamic Development Bank,
Jeddah.
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