Fed ought to consider global bubbles

October 11, 2010

Sound monetary policy it might be said, begins at home. The prime goal of the Federal Reserve is to nurture a sound U.S. economy. But it would be naive to ignore the fact that Fed policy also drives markets around the globe. And at present the Fed risks blowing global bubbles, with potentially damaging effects.

The bubble blowing begins with beliefs about the Fed’s thinking. In the past few weeks the understanding has become that the Fed favours a second round of quantitative easing. The impacts have been many: a sharp fall in the dollar against the euro, yen and many emerging market currencies, appreciating bonds and equities in the developed world and emerging markets, a new record gold price, and a jump in global commodity prices to two year highs.

Many of these effects might be deemed desirable. A weak dollar favours U.S. exports. Commodity price inflation favours emerging market export earnings and is more conducive to global recovery than tumbling prices. And buoyant asset markets can certainly be judged more helpful than collapsing ones. But the financial moves risk becoming excessive. The West is ailing in large measure because first stock, then property bubbles burst. It would be unfortunate if new bubbles were to be conjured in emerging economies.

Emerging market governments are conscious of the risks. This is why many are considering following Brazil’s lead and imposing capital controls. Currencies that soar when the dollar and yuan remain weak can mean export markets are lost. Medium-term damage may therefore be done by short-lived bubbles. More countries may consider emulating China and fixing their exchange rate. That would be unfortunate.

There is also an inflation risk from commodity prices. Already India is plagued by food price inflation. And if commodity prices keep spiraling, Western economies, too, may find consumer spending is harmed by an excess of inflation rather than the lack of it.

The Fed is testing the limits of loose money. It may fear that more quantitative easing may have a limited impact on the pace of U.S. recovery. But the impact around the world risks being big — and unhelpful. The Fed should keep the global picture in mind.

Comments

Further easing would be overdoing it in my view. If economic conditions were to reverse quickly, the FED would also have to move quickly, but history has shown that they usually react too slowly. I also think that further easing would not make much difference anyway. Like throwing more wood on a fire that burnt out long ago. Totaly pointless.

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