Not Backing the Buck

June 17, 2008

Yesterday’s Page One article in the Journal suggested the Fed is in no rush to boost interest rates to protect the value of the dollar:

The Federal Reserve is almost certain to leave interest rates unchanged when it meets next week, and it currently doesn’t appear to see a compelling case for raising rates before the fall, unless the inflation outlook deteriorates considerably. [See this tutorial to help understand how higher interest rates may impact the dollar’s value.]

Hmmm. Ben Bernanke said last week that exploding energy prices were causing the inflation outlook to deteriorate:

“The latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations,” he said in a speech on June 9. He said that the Fed “will strongly resist” allowing inflation expectations to get out of hand. When people believe prices are bound to rise, workers tend to seek wage increases and businesses to mark up their prices, boosting inflation.

But Bernanke’s hands may be tied by the Fed’s “dual mandate:” its twin, and often conflicting, directives to achieve low inflation AND low unemployment. Raising rates to fight inflation and protect the dollar will likely deepen the economy’s funk by driving house prices down even more.

The chart above gives you an idea why Bernanke’s dual mandate makes his life so difficult. If you look closely, you can see that inflation and unemployment tend to be inversely related. When inflation is high, unemployment tends to be low. And vice versa. It’s hard to combine low inflation with low unemployment for a long stretch. And yet we’ve come to expect that from our central bankers after years of low unemployment and low inflation. Just check out the chart in the years after 1993. We’ve benefited immensely from trade and technology, which together have kept inflation and unemployment low. Unfortunately, those benign economic conditions are likely coming to an end, which means Bernanke once again faces The Choice: fight inflation or keep the economy out of “recession.”

Whichever strategy he chooses, his primary weapon is raising or lowering the Fed Funds interest rate, which is the third variable I’ve included in the chart above.

When newspapers speak of the Fed changing “interest rates,” they are typically referring to a change in the Fed Funds rate. Interest rates across the economy are closely tied to this particular rate so when the Fed raises it, other interest rates tend to move in tandem. If the Fed wants to slow down economic activity in order to fight off inflation, it can do so by raising rates. But a slower economy typically means higher unemployment.

It’s the classic “rock and a hard place” conundrum.

Since last Fall, Bernanke has aggressively cut rates to spur economic activity. And yet this has unleashed the inflation demon worldwide, hitting developing economies especially hard.

And now we arrive back at the top of this post, and Bernanke’s recent rhetoric that he’ll remain vigilant in the fight against inflation. But vigilance requires action, and as the Journal piece noted, Bernanke & Co. don’t seem inclined to back up their anti-inflation talk with anything other than words. Rate increases aren’t likely in the near future. One big reason is that interest rate hikes could hammer an already depressed housing sector.

As house prices fall, household “wealth” declines. It also reduces the amount of equity that consumers can turn to cash with the help of home equity loans (For a fascinating and brief discussion of mortgage equity withdrawal, see the first two pages of Paul Kasriel’s commentary from 6/13). With less access to easily borrowed cash, consumers spend less. In an economy driven by consumer spending, less cash in consumers’ pockets likely means recession. And recession means higher unemployment.

Declining house prices are but one example of how higher interest rates depress economic activity. For a clearer picture, juxtapose Paul Volcker’s early 80s rate hikes with unemployment data. To beat inflation he raised rates to 20%, which you can see from the chart had a strong impact on unemployment: driving it over 10% for the first—and still only—time since WWII.

But the medicine worked. Volcker beat inflation and sowed the seeds for perhaps the greatest economic expansion in American history.

Personally, I’m watching foreign central banks closely to see which ones are most Volcker-like. Those erring on the side of TOO tight monetary policy are likely to be most successful at beating inflation, setting themselves up for long-run economic growth. In the short-run, tight monetary policy certainly isn’t great for the economy. But it’s the long-run that matters. And I daresay one of the most important factors leading to long-run economic growth is a stable currency.

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