Fed pause promises financial disaster
By Hossein Askari and Noureddine Krichene
On the heels of the most expansionary monetary policy in the post- Word War II
period, pushing the US ratio of domestic credit to gross domestic product to an
unsustainable 226% in 2007 as compared with 184% in 2000 and 142% 1980
respectively, the US Federal Reserve has adopted an even more aggressive
expansionary policy since August, with the stated objective of re-inflating the
economy to jerk up housing prices and bail out failing banks.
In the process, the Fed has pushed the dollar further down and accelerated
inflation in energy and food prices, causing oil prices
to race from US$70 per barrel to $126 per barrel, and food prices to levels
that have resulted in malnutrition and riots.
Given that money policy works with a lengthy and variable lag, accelerating
energy and food prices are the delayed effect of significant interest cuts and
money expansion since August 2007. The indication is that inflationary
expectations have become entrenched and strongly footed in world markets.
Most ominous is the fact that by turning real interest rates negative, the Fed
has intensified speculation and put energy and food markets under accelerating
and boundless rising pressure. Commodity prices have become predictable for
even the non-expert; conditional on the Fed's current stance, pick up any
number for oil, $150/bl, $200/bl, $250/bl, and we will be there. Similarly for
rice, corn, and wheat. The Fed has made speculation more remunerative, credit
riskier, and financial savings less attractive.
Basic money theory postulates that prices cannot sustain a general increase
without an accommodative money and credit expansion. That is the basic quantity
theory of money. Therefore, the rise of oil from $20 to $126 could not have
occurred under restrained and stable monetary policy. The same goes for corn,
rice, milk, and on and on - a twofold or threefold price increase cannot take
place without an unduly expansionary monetary policy.
What is absurd is that the Fed does not react to abnormally high energy and
food prices, that is, what is referred to as Keynes' wage goods. It reacts only
to core inflation. In other words, when prices of basic food commodities,
including bread and butter so necessary for children, triple or quadruple, this
causes no concern to the Fed, because they are not part of core inflation.
However, when toys prices go up by 10%, they may become of some concern to the
Fed, signaling that core inflation is rising! But with workers struggling to
put food on table, they are less concerned with buying toys. Hence, toy prices
may never increase, core inflation may not rise, and the Fed may never respond
to racing energy and food prices.
Alarming signs of deteriorating global food shortages and an impending world
stagflation, stemming from the Fed's policy, are now pervasive. World energy
and food markets have become critically fragile in the face of mounting
speculation and inflationary expectations. The falling dollar and accelerating
inflation will certainly depress both the global demand and supply of
As money depreciates, suppliers of commodities, already straddled with piling
international reserves, will supply less as their expectations of higher prices
and revenues are fully met. The evolving food crisis seems to have no precedent
in modern history. While severe food shortages are developing in many
vulnerable countries, media-interviewed shoppers in the US have sadly responded
that they have been forced to dramatically curtail their food consumption.
Rampant energy and food prices will threaten social stability and will
certainly undermine the Fed's objective of re-inflating home prices. Unless
mortgage loans are showered without down payments and income checks, as was the
practice during the recent housing boom, prospective home buyers will be
preoccupied by simple survival and will be less willing to take on more debt.
Energy and food price inflation will depress further highly overvalued home
With inflationary expectations becoming strongly entrenched, the risk of global
stagflation has become significant. A drawn-out inflationary process always
precedes stagflation, anathema to the so-called Phillips Curve. Following the
attritional effect of inflation, the economy starts to grow below its
potential. It experiences a persistent output gap, rising unemployment, and
increasingly entrenched inflationary expectations.
Data for the 1970s shows that the 1975-82 stagflation took place despite high
interest rates, financially stable environment (domestic debt to GDP was at
138% in 1975), plentiful world food supply, and large crude oil spare capacity
with plentiful supplies.
The cause of stagflation was accelerating inflation in the US and the rest of
the world during 1969-74, a falling US dollar, and depressed aggregate demand
in the rest of the world. Based on the data for the seventies, it could be
argued that the drawn out inflation since 2003 has gained a strong enough
momentum in 2008 to cause a period of more severe world stagflation than the
one experienced in the 70s. The severity of stagflation will stem from very low
interest rates, unsustainable credit expansion, severe limitations on oil and
food supplies and abnormally high energy and food inflation. All these factors
will contribute to intensifying inflation and at the same time to crippling
world aggregate demand and supply.
Cut interest rates and then pause, such was the Fed's recent decision. Pause
for what? For more instability? Maintaining the Federal Funds rate at 2% means
that the Fed will supply any amount of liquidity required to achieve this
target. This policy will depreciate money, put an end to prosperity, and
disrupt world energy and food equilibrium.
Unless policymakers understand the disruptive real effects of overly
expansionary monetary policy, the energy and food crisis may worsen beyond
manageable limits and put at risk millions of lives. Addressing inflationary
expectations is not costless. World energy and food markets can be stabilized,
but only when the Fed renounces interest rates control and reins in monetary
and credit expansion to a stable range. This is exactly what Paul Volcker did
successfully during his tenure as Fed chairman.
Economists and the US Congress must convince the Fed to concentrate on managing
liquidity, which is under its total control, and give up managing the entire
economy, which is not under its control. After seven years of inflationary
monetary policy, there is now more pressing need than ever for stabilization
policies to address inflation and energy and food crises.
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.