Central Bank Schizophrenia

June 30, 2008

The Fed’s critics have complained very loudly since Ben Bernanke began lowering interest rates last Fall. They argue that low interest rates encourage more borrowing and consequently more spending. And that low interest rates depress the the foreign exchange value of the dollar. They say all of the above are driving inflation higher and point to exploding food and oil prices worldwide as evidence.

For his part, Bernanke has said that risks to economic growth “outweigh” the risks of higher inflation. That is why he had continued to lower interest rates despite the threat of inflation. (until last week anyway)

Just today, the Bank for International Settlements published a schizophrenic report in which they argue that the end of the credit boom poses more serious threats to the world economy than the “consensus view seems to expect. At the same time, inflationary forces…could prove unexpectedly strong and persistent.” Translation: growth is slowing more quickly than people expect while inflation is accelerating more quickly than people expect.

What is Ben Bernanke to do? Since his job is simultaneously to avoid recession while protecting against inflation, and right now there’s evidence he faces both problems, he’s in a difficult spot. This is because the policy prescription to fix anemic economic growth will tend to increase inflation. But the prescription to fight inflation will suppress economic growth. You might say Bernanke is between a rock and a hard place. Or up shit creek.

At the end of the day, the problem is Bernanke’s dual mandate. Maintaining price stability while encouraging economic growth are often conflicting goals.

Personally, I think the Fed’s job description should be simplified. They should be charged only with fighting inflation. After all, the Fed’s medicine for supporting economic growth is simply to increase credit throughout the economy. Too much credit has allowed Americans to live beyond their means for more than a few years. It has encouraged spending at the expense of saving.

It’s time America’s credit cards were cut up. A quick glance at aggregate commercial bank credit (see chart 2) suggests that is exactly what is happening. And yet the Fed is concerned that if credit dries up too quickly, that the American economy will fall into recession.

If that’s what needs to happen so be it. Over the last few years the American economy has been “growing” artificially, by means of credit expansion as opposed to wealth creation. The Fed should be less concerned with preserving artificially obtained wealth and more concerned protecting the value of Americans’ savings. Protecting the value of the dollar must be paramount, not bailing out overstretched borrowers.

(For more detail on the problem of Bernanke’s conflicting mandates, see this post.)


On another note, this week’s Economist has a couple articles on topics discussed here over the past month. Their foreign affairs leader suggests that Israel’s threat to bomb Iran may not be a bluff, which was covered here last week. Also, one of the articles featured on the cover discusses the stunning inflow of “hot money” into China, covered here a month ago.

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