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     Jan 15, 2011

No hunger at the Fed
By Hossein Askari and Noureddine Krichene

Food and energy prices are raging upwards once again, forcing governments in China, India, Brazil, Russia, and others to ring the alarm bells. The United Nations Food and Agricultural Organization (FAO) has announced that in December 2010 food price inflation broke records, with the world food price index exceeding its peak level of 2008.

With gold prices racing beyond $1,400/ounce, rising by 30% in 2010, oil prices about to cross the $100/barrel, rising by 25% in 2010, and the US dollar crumbling, it is hardly surprising to see food prices also explode at alarming rates.

In contrast to their counterparts in many leading countries, US


policymakers do not appear alarmed by energy and food price inflation; in fact, it has hardly made it onto their agenda. Even though prices of sugar, wheat, corn, coffee, soybeans, and many other basic food, such as onions and cooking oil, rose at rates ranging between 60%-80% in 2010, this inflation seems to have been of little concern to the Federal Reserve.

In his testimony on January 7 before the Committee on the Budget of the US Senate, Fed chairman Ben Bernanke remained committed to fighting low inflation: "FOMC [the rate-setting Federal Open Market Committee] participants also projected inflation to be at historically low levels for some time. Very low rates of inflation raise several concerns."

Bernanke was concerned about impact of low inflation on borrowers: "With short-term nominal interest rates already close to zero, declines in actual and expected inflation increase, respectively, both the real cost of servicing existing debt and the expected real cost of new borrowing."

Most interestingly, Bernanke argued that high inflation increases wages and incomes and translates into rising living standards and that low inflation would cause a loss in real incomes: "It is important to recognize that periods of very low inflation generally involve very slow growth in nominal wages and incomes as well as in prices. Thus, in circumstances like those we face now, very low inflation or deflation does not necessarily imply any increase in household purchasing power. Rather, because of the associated deterioration in economic performance, very low inflation or deflation arising from economic slack is generally linked with reductions rather than gains in living standards."

The contrast between US perceptions and policies and that of much of the world is startling. While a number of major countries are battling inflation and are alarmed by food and fuel price inflation, Bernanke is battling low inflation, or imaginary deflation, and is determined to inject US$600 billion to prevent low inflation and achieve higher inflation, as per the Fed's mandate to achieve full-employment.

Bernanke's theory could imply that 10% inflation per year is better than 3%, 50% is better than 10%, and 100% is better than 50%. Even though a large number of US consumers are suffering from higher fuel and food prices, with about 50 million on food stamps, there seems to be little sympathy from the Fed.

Believing Bernanke's testimony that food and energy price inflation raises real incomes and that by itself brings prosperity would be hardly sensible. If a politician were to tell consumers in India that they should be happy to see onion prices double from what they were just a few months ago as this was a sure sign of pending prosperity, he would be ridiculed. Similarly, if a politician tells Chinese consumers that they should be happy with cooking oil prices three times the level of a few months ago they would think him insensitive to the plight of the average Chinese.

Nonetheless, supporters of inflationism regard higher inflation as the best strategy for promoting growth and full-employment. How high inflation should be? Inflationists portray money printing as conducive to real economic growth. It costs nothing to print paper money. So why deprive the state, consumers, and firms from free wealth and from lavish spending? It would be preposterous to deny government and consumers money when money is costless to print!

But seriously, with record fiscal deficits, there could be a need for inflation to finance these deficits, by keeping interest rates near zero, and practicing a Ponzi scheme consisting of eroding real debt through rapid inflation. High inflation would erode real value of debt owed to China and other foreign creditors; it would reduce real debt and real borrowing cost for the US government and for domestic borrowers, including mortgage borrowers.

At a time that the US Treasury is calling for an increase in the debt ceiling to finance higher fiscal deficits, there is every good reason for the Fed to ignore food and energy price inflation to combat low inflation and to keep interest rates near zero level.

If Bernanke were to admit that there is rampant food and energy price inflation in the US and that it could accelerate and spread to other sectors, he could no longer defend his policy to fight low inflation.

Irrespective of criticisms from a number of quarters, the Fed has for years remained insensitive to speculative housing prices and food and energy price inflation until such inflation ravaged the banking sector, the housing sector, and sent the US economy into the worst recession in post-war period with unemployment approaching 10% in 2010 from 4% in 2007 and unprecedented peacetime fiscal deficits.

In a recent interview with Wall Street Journal, Bernanke's predecessor at the Fed, Alan Greenspan, challenged his critics to prove that he had been wrong in his policies. Even though housing prices were doubling, tripling, and quadrupling, speculation was rampant when he was Fed chairman, and credit exploding at 12% a year, he was convinced that he was fighting deflation, and, therefore, his policies were appropriate!

Hence, as in the past, Fed policy remains unchanged; it fights low inflation with unlimited injection of liquidity and near-zero interest rates, which unfortunately also promote speculation.

Support for such a policy has been clearly re-iterated by Bernanke: "In a situation in which unemployment is high and expected to remain so and inflation is unusually low, the FOMC would normally respond by reducing its target for the federal funds rate. However, the Federal Reserve's target for the federal funds rate has been close to zero since December 2008, leaving essentially no scope for further reductions. Consequently, for the past two years the FOMC has been using alternative tools to provide additional monetary accommodation. Notably, between December 2008 and March 2010, the FOMC purchased about $1.7 trillion in longer-term Treasury and agency-backed securities in the open market ... At its meeting in early November, the FOMC formally announced its intention to purchase an additional $600 billion in Treasury securities by the end of the second quarter of 2011, about one-third of the value of securities purchased in its earlier programs."

The resurgence of record food and energy prices could bring economies back to the nightmare experienced in 2008. At that time, agriculture, airlines, transportation, the auto industry, and many other sectors were also paralyzed. The number of food stamp recipients surged. At the same time, the number of poor people suffering malnutrition in Mauritania and other vulnerable countries rose by the millions. Governments were in disarray and held world food and energy summits, with a view to "permanently" solving food and energy crises.

Food and energy price inflation will again play havoc with many economies as it did in 2008 and could in turn bring economic growth again to a standstill in a number of countries. This time again, food and energy price inflation will remain unchecked, speculation will intensify, and the adverse effects will keep on compounding; it will hurt food and energy importing countries and slow economic growth worldwide.

Central bankers have not articulated the disruptive role of energy, food, and housing price inflation for growth and triggering economic crises. Chairman Bernanke, renowned academics, and much of the media blamed fuel and food price inflation during 2002-2008 on high demand in China and India. Looked at as an Indo-Chinese problem, food and fuel price inflations were thus a non-issue; left to burn out themselves, ravaging economies and precipitating long recessions.

In the recent past, periods of economic stagflation have been associated with high food price inflation. On the one hand, during the stagflation of the 1970s, food price inflation averaged 12.5% per year during 1970-80. On the other hand, periods of steady economic growth were associated with stable or declining food prices. The period 1982-2000 was marked by steady economic growth with food prices dropping by 2% per year. During the period 2005-2007 leading up to the financial crisis, food prices were rising at 16% per year. Food prices accelerated from August 2007 to July 2008 at an annual rate of 41%, leading to a standstill in economic activity and negative real GDP growth of 2% in the US.

Food and energy price inflation jolted many economies in 2008. Food price inflation and energy price inflation are likely to get worse. They may even accelerate at a faster rate than observed in 2010.

The Fed will have injected $600 billion on the top of the already injection of $1.7 trillion; this would make about $2.3 trillion in money created out of thin air. The US Fed has put no food or oil on the markets; it cannot put one gram of onion or one drop of cooking oil on the market. It has only printed more and more money.

Significant money creation amounts to a tax and a redistribution of wealth and real resources in favor of recipients of the created money at the expense of workers. The recipients of this money will be beneficiaries of money creation at the expense of those who loose through high inflation. The new money will translate into higher demand for food, energy, and other commodities, and progressively into higher prices. Such money creation, in turn, destroys savings and real investment.

Food and fuel prices are determined in speculative markets that are swamped with liquidity at near-zero interest rates. The determinants of food and fuel price inflation will only worsen; these determinants are the continuous depreciation of the US dollar, the currency of denomination for commodity prices; near-zero interest rates in the US, Europe, Japan, and in many other countries; dangerous levels of fiscal deficits in the US and in many Europeans countries; money printing by the Fed, the European Central Bank, and a number of other central banks; and a developing currency war, with most countries inflating at the same rate as the US to prevent an appreciation of their currencies vis-a-vis the US dollar.

All these factors could compound to make food price inflation even worse and more durable than observed during 2002-2008.

Major central banks, including the Fed, are unlikely to be moved by food price inflation. Speculators know that US policy will remain most propitious to speculation in commodities and asset markets.

A country that wants to insulate itself from food price inflation has to appreciate its currency significantly; this would mean a significant loss of competitiveness; or, it has to subsidize food prices. Absent these two drastic measures, countries have to live with the implication of unorthodox US monetary and fiscal policies.

Food and energy price inflation will tax fixed pension incomes and workers' wages, which lag considerably behind inflation. It will force real cuts in food consumption. Food and fuel price inflation, as any other inflation, will certainly benefit producers and sellers, as inflation always increases substantially profits and redistributes wealth at the expense of the workers.

Inflation (the outcome of excessive money creation), large fiscal deficit financing that finance wars and political spending, and unsound government policies have been rarely conducive to increasing real supply or to sustainable economic growth. It is more a symptom of highly distorted and politically imposed policies than a sign of prosperity.

As producers notice that inflationary expectations have become embedded and that money is depreciating at faster rate, they would be inclined to bid for constantly higher prices and would tend to hoard and reduce real supplies. The more their expectations of higher prices are validated, the less they will produce, and the faster inflation becomes. The dynamics of inflation are such that inflation could turn into hyperinflation, disrupting production and trade. Examples of hyperinflation are numerous both in distant and recent past.

The US is trapped in the vortex of inflationary policies: a combination of the largest peacetime fiscal deficits in its history, rising public debt, near-zero interest rates, and excessive injection of liquidity. The Fed has regarded money printing and near-zero interest rates as the best policies to secure economic prosperity and full-employment, even though these policies have already ruined banks in the US and in Europe and have rewarded speculators.

A combination of overwhelming fiscal deficits and most unorthodox monetary policies in the US offers little hope for quick relief from fuel and food price inflation, which has plagued many countries and millions of consumers in the past eight years.

Hossein Askari is Professor of International Business and International Affairs at the George Washington University. Noureddine Krichene is an economist with a PhD from UCLA.

(Copyright 2011 Asia Times Online (Holdings) Ltd. All rights reserved. Please contact us about sales, syndication and republishing.)

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