Fed fails to learn inflation
lesson By Hossein Askari and
Noureddine Krichene
Since 2002, a number
of key indicators have signaled rapid inflationary
pressures, casting an ominous cloud over the US
economy: the US dollar has depreciated by about
75% relative to the euro, crude oil prices have
increased fivefold, gold prices have increased
threefold, and all commodities prices have been
rising at a rate approaching 25% per year.
In all likelihood, the US economy is
reliving the inflationary period of 1968-1982, a
period characterized by severe stagflation with
inflation reaching 14.68% a year in 1980 and
unemployment reaching 11.4% in 1983.
Historically, inflation has been
considered public enemy number one. It is caused
by excessive money supply and a too
rapid
expansion of aggregate demand
for goods and services in relation to available
supplies.
Inflation brings impoverishment
and prevents full employment. It penalizes cash
holders by extracting a heavy tax on their cash
balances and reduces the purchasing power of wages
and fixed incomes (such as pensions). It forces an
unjust redistribution of wealth in favor of
debtors and speculators at the expense of
creditors. It encourages capital flight. It
distorts relative prices by increasing the price
of most basic necessities prices (energy, food,
clothing, rent) for which demand cannot be easily
reduced in response to price increases. It weakens
productivity and competitiveness. Inflation has
brought economic decay and social unrest and
eroded the foundations of economic growth.
There is no field in economics that has
drawn more attention in the last four centuries
than the topic of inflation. The causes of
inflation are well known and have been analyzed by
some of the most noted economists of all time,
such as John Maynard Keynes and Milton Friedman.
The roots causes of inflation are monetary
in nature, stemming from excessive money supply
provided by the central bank and the banking
system. Inflation operates through a lag that is
variable and long. If the economy shows early
signs of vulnerability to ongoing inflation
process, in form of incipient economic recession
and accelerating prices of basic necessities such
as food products, then inflation has reached
mature stage and has worked its effects through a
number channels, including: (i) falling supply of
goods and services; (ii) a credit crisis triggered
by bad loans; (iii) a large depreciation of the
exchange rate and large capital outflows; (iv) a
decline in purchasing power of wages and pensions
following a drawn out inflation process; (v)
redistribution of demand away toward basic
necessities entailing layoffs in the sectors for
which real demand is falling; (vi) a fall in
demand for durables and investment goods; (vii)
declining real savings; (viii) higher credit risks
and a decline in real credit and (ix) higher
transactions cost, a decline in demand for money
and financial assets, and a flight toward real
assets, such as oil and gold.
The dilemma
for policymakers is that they can fail to
appreciate the strength of the underlying
inflation and their response can be expansionary
policies to reverse an impending recession. At
this stage, an expansionary stance will only
reinforce the strength of the inflation process
and inflationary expectations, may lead to
substantial increase in nominal wages, and
therefore faster layoffs in the sectors for which
demand has already fallen in the early stage of
inflation. Inflation can thus become a demand
pull-cost push phenomena, with central bank and
banking system accommodating any demand for
liquidity and risky borrowing. The process cannot
go on indefinitely.
The proposed solution
of prominent monetarists has been to act promptly
to arrest the inflationary process by reducing
money supply because they believe that inflation
is at its core a monetary phenomenon. Fearing the
dangers of inflation, Keynes advocated decisive
and immediate action against inflation and warned
against a gradual approach, which he considered as
ineffective and socially costly.
The
ongoing inflation in the US, as noted by Joseph
Stiglitz, can be placed at the doorstep of the Fed
which, following an interest rate rule, has set
interest rates at the lowest post-war levels of
2002-2004.
As a result, domestic credit
has expanded too rapidly. In turn this has
resulted in a higher supply of dollar on global
markets and the consequent depreciation of the
dollar has led to the most rapid historical
increase in commodity prices, including crude oil
and food. Facing abnormally expanding liquidity,
banks have accumulated higher risk credit and
fuelled speculation.
Friedman passionately
criticized the interest rate rule. Before him, in
1898, Wicksell denounced the interest rate rule.
He developed the notion of two interest rates: the
neutral real interest rate, that is, a rate that
causes no change in general price level, which is
defined as the rate that equates real aggregate
demand with real aggregate supply at full
employment and a stable price level, and the
nominal bank loan interest rate at which banks
lend money.
He introduced the notion of a
cumulative process through which inflation can
make any interest rate on a bank loan profitable
by driving the real interest rate substantially
below the neutral real interest rate. He showed
that the interest rate rule distorted prices in
the economy, namely market forces that equilibrate
demand for investment with savings, or
equivalently aggregate demand with aggregate
supply no longer determine the price of capital.
To any interest rate fixed by the central
bank there will correspond an unlimited expansion
of bank credit that will generate inflation high
enough to make real interest rates negative.
The yield curve (the spectrum of interest
rates for bonds of differing maturities) will not
reflect inflationary expectations as interest
rates are set by the central bank and the market
for loans is driven by unlimited financing from
the central bank and the banking system, including
financing for the bailout of illiquid
institutions.
Bondholders cannot ask for
an inflation premium, as the banking system will
absorb profitably any amount of bond issues. The
whole interest structure is fully determined by
central bank at any level it elects. Financial
markets keep asking the central bank to cut
interest rates when stock indices fall. Real
interest rates become largely negative. Financial
savings decline rapidly.
If the central
bank gives up at a certain point control of
interest rates, these will explode instantaneously
to extremely high levels to equate the real
interest rate with the natural rate and in the
course of time they will trigger a monumental
credit crisis and large government deficits when
bonds yields go up dramatically. At the same time,
bond prices will fall sharply and bondholders will
incur large capital losses. It is not a pretty
story but one that could describe the US unless we
are careful.
Lessons from past US
inflationary episodes have to be revisited and
learned. The Fed tried unsuccessfully during
1968-79 to use the interest rate policy rule to
control inflation. The Fed kept increasing its
chosen interest rate, yet inflationary
expectations became self-fulfilling. Unemployment
kept rising. Only when the Fed adopted, with an
11-year delay, the solution proposed by
monetarists that called for controlling monetary
aggregates, did inflation become fully subdued.
Interest rates shot up, reflecting repressed past
adjustment.
Had the Fed applied this
solution in the early stage of inflation, that is
in 1968, it would have precluded Richard Nixon's
price controls of 1971 and it would have avoided a
long and costly inflation process with both
inflation and unemployment rates reaching two
digit rates.
The present Fed is adopting
diametrically opposite policies to the ones
adopted by the Fed during 1968-79. While the Fed
was constantly increasing interest rates to
unusually higher levels to stem inflation during
1968-79, the present Fed is reducing already low
interest rates and injecting considerable
liquidity at a time when inflation has become a
fully established process, thus contributing to
increasing vulnerability of the financial system
to future credit crises and supporting
speculation.
Such an approach is hazardous
and may destabilize the US and global economy even
further. The US dollar will keep falling to record
lows, money will depreciate, the price of basic
necessities will jump to higher records, the trade
deficit will increase, and needed capital inflows
to support the US current account deficit will dry
up with even more ominous implications for the
dollar.
Controlling monetary aggregates,
reducing money supply and renouncing interest rate
controls should be the most pressing priority for
US policymakers and is the only effective solution
to rampant inflation and a falling dollar.
The monetarist model does not aggravate
recession; it reduces length and amplitude of
stagflation. Inflation lost its momentum rapidly
when the Fed controlled bank reserves during
1979-82 and price stability was finally restored.
Controlling monetary aggregates and
eradicating inflation will rebuild confidence,
revive investment and growth, and unleash the
forces of supply and competitiveness. Economists
who oppose price controls should oppose interest
rate setting by the central bank. If monetary
restraints and discipline are not implemented
soon, the US economy will suffer prolonged and
devastating inflation that will be much more
costly in terms of employment and growth for a
generation.
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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