Tuesday, January 18, 2011

Where is the Inflation? All Around!

Ronald McKinnon writes in the Wall Street Journal this morning, “The U. S. is a sovereign country that has the right to follow its own monetary policy. By an accident of history, however, since 1945, it is also the center of the world dollar standard...So the choice of monetary policy by the Federal Reserve can strongly affect its neighbors for better or worse.” (http://professional.wsj.com/article/SB10001424052748704405704576064252782421930.html?mod=ITP_opinion_0&mg=reno-wsj0

Charles Plosser, President of the Federal Reserve Bank of Philadelphia, stated in Santiago, Chile yesterday: ”I believe we have come to expect too much from monetary policy.”

In terms of what monetary policy can do, we know that one of the fundamental lessons of economics is that “Inflation is, everywhere, at every time, a monetary phenomenon.”

Monetary policy cannot produce full employment, or retract over-investment, or fund state and municipal government pension funds that have been under-funded for years. Monetary policy cannot educate or train people for today’s jobs.

Monetary policy cannot make commercial banks solvent that have made bad loans or investments.

McKinnon asks, “What do the years 1971, 2003, and 2010 have in common? In each year, low U. S. Interest rates and the expectation of dollar depreciation led to massive ‘hot money’ outflows from the U. S. and world-wide inflation. And, in all three cases, foreign central banks intervened heavily to buy dollars to prevent their currencies from appreciating.”

But, the U. S. is a sovereign country that has the right to follow its own monetary policy...

And, how is this happening?

First, money flows into auction markets such as commodity markets or foreign exchange markets. (http://seekingalpha.com/article/246657-emerging-markets-the-bubbles-are-real)

Second, funds begin to flow into other areas of non-United States economies. Consumer price indexes have been rising in many of the emerging countries around the world. In particular, China, Brazil, India, and Indonesia have experience increases in their price indexes of more than 5% in 2010. In both the Eurozone and in England, the central banks are having to deal with the problem that, despite slow economic recovery and reductions in government spending due to the sovereign debt crisis, recorded inflation is exceeding their long run inflation targets.

Only after some lag time takes place does the inflationary pressures get built up within the United States. This lag time may be as much as five years, especially given the structural problems that exist in the United States economy. (http://seekingalpha.com/article/246404-why-debt-is-going-to-continue-to-be-problem-for-u-s) This is the historical experience.

Notice, that in two out of the three dates that McKinnon highlights, Ben Bernanke played a prominent role. Bernanke was a board member of the Federal Reserve during the 2003 time period and helped to compose the justification for the Fed’s policy at that time. Of course, Bernanke is currently the Chairman of the Board of Governors.

One must also remember that it was Chairman Bernanke who continued to fight inflationary pressures into the late summer of 2007 before the Fed totally had to reverse their policy stance when Bear Stearns declared bankruptcy. (http://seekingalpha.com/article/188342-model-misbehavior-the-quants-how-a-new-breed-of-math-whizzes-conquered-wall-street-and-nearly-destroyed-it-by-scott-patterson)

Mr. Bernanke does not have a very good record in judging when he, and the Fed, are heading in the wrong direction. Zero for three is not a very good batting average!

The consequences of inappropriate economic policy work themselves out slowly, but they also inevitably work themselves out. This is the message in the research of Ken Rogoff and Carmine Reinhart. (http://seekingalpha.com/article/171610-crisis-in-context-this-time-is-different-eight-centuries-of-financial-folly-by-carmen-m-reinhart-and-kenneth-s-rogoff)

Here we need to quote another fundamental lesson of economics: monetary policy works with long and variable lags.

Monetary policy takes a long time to work itself out throughout the economy. And, the effects of monetary policy cannot be reversed quickly.

One of the reasons why some economists have argued that monetary policy should be conducted according to “rules” rather than “authority” is that, historically, the track-record of policy makers is not so “hot.” And leaders that have a batting-record of zero for three do not add anything to the confidence level.

Where is the inflation?

It can be found throughout the world. The United States is “the center of the world dollar standard.” What the United States does in terms of monetary policy affects the world! And, what is happening in the world, sooner or later, also affects the United States. McKinnon is arguing that this is the historical record.

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