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     Jun 4, 2008
The Fed's unholy legacy
By Hossein Askari and Noureddine Krichene

Not a day seems to go by without a headline proclaiming that gas and food prices have hit a new high and that the dollar is at a record low. Most recently, rising food and energy prices have grabbed global attention with food and gas riots in a number of vulnerable countries. The US dollar is wobbling on a knife-edge with potentially ominous consequences for world trade and financial stability.

This chilling landscape has been brought about by an overly expansionary monetary policy in the US, historically low nominal interest rates coupled with negative real interest rates over a number of years, with an explosion of debt, savings that have evaporated and economic growth that will be compromised for a


number of years to come. And there is no end in sight.

Since August 2007, the US Federal Reserve Board has resumed its aggressive and addictive policy of cutting interest rates and re-inflating the economy in a bid to correct its past errors (most recently the housing bubble) and to stem a recession.

These Fed policies have contributed to more price instability, accelerated inflation, precipitated the US economy into stagflation, and undermined the dollar

The Fed's re-inflation policy will push credit to an even more unsustainable level and will only put off an even more serious credit crisis. At the same time, the Fed's inflationary policy will implicitly continue to tax dollar holders, fixed-income and wage earners and creditors, in favor of speculators and debtors, including imprudent banks.

It will deteriorate food conditions and the standard of living of millions of people, and will trigger rising unemployment. The Fed seems to ignore the quantity theory of money, which simply states that, under strong inflationary expectations, prices will increase at a much faster rate than money supply. Given severe short-run constraints on oil and food supplies, further credit expansion will serve only to exacerbate price acceleration into a hyperinflationary range.

Created in 1913, the Fed was entrusted with a mandate to safeguard price and financial stability, a pre-requisite for sustained economic growth and high employment, by controlling money supply and credit creation.

The Fed was supposed to use the standard tools of bank reserves, credit and money aggregates to achieve its goals, while interest rates were to be market-determined. The 1951 Fed-Treasury Accord was a step towards avoiding dangerously (inflationary) low interest rates that supported the Treasury's desire for low interest payments on government debt.

Yet many inflationary episodes since 1951 can be directly attributed to the Fed's adoption of an excessively loose monetary policy and its inability to reverse course in a timely manner. Moreover, the Fed has adopted a narrow concept of price stability by focusing only on the consumer price index and not having a more encompassing view that includes the prices of all assets, commodities, exchange rate, and goods and services.

Had the Fed reacted in a timelier manner to deal with explosive housing prices, the present financial and housing crisis could have been avoided.

What has gone wrong? The Fed was created as an independent institution to preserve the value of the US dollar and to promote financial stability. Unfortunately, in retrospect this independence has afforded the Fed too much discretionary and arbitrary power. It was precisely for this reason that Milton Friedman wrote that "a monetary rule would insulate monetary policy both from the arbitrary power of a small group of men not subject to control by the electorate and from short-term pressures of partisan politics".

By deviating from its mandate, the Fed has become a destabilizing force and is actively destroying the value of the dollar and the stability of the global financial system. While the Fed thinks that cutting interest rates is a panacea for every economic problem, macroeconomists have long abandoned this view and have developed richer approaches that includes fiscal, monetary, exchange rate, trade, growth and sectoral policies.

As the ongoing inflationary process evolves, the social, economic, and financial consequences could become overwhelming. For how long will the Fed continue to deviate from its mandate and do more of the same?

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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