Expansionary Monetary Policy is Infectious

The Federal Reserve’s announcement yesterday makes it clear that we should see its leadership as radical incrementalists.  They will move in distinct incremental steps, some small and some larger, but they will do whatever it takes to prevent deflation.  And that means they will do what it takes to make sure that inflation remains (or goes back to being?) positive.  If they need to err on the side of slightly higher inflation, then so be it.  This is pretty radical (and a good idea, in my opinion.)

What effect does this have on the rest of the world?  Well, if your central bank now sits idly by, most likely you will experience an appreciation of your currency relative to the US dollar.  (The caveat, of course, is that if you have a new major domestic disruption in your banks, or another member of your currency union runs into refinancing trouble, you could still experience a depreciation.)

Who is willing to experience a significant appreciation in a slowing global economy, with exporters everywhere already clamoring for assistance?  Most central banks will be pressed hard to ease further, either with interest rate cuts or their own version of “quantitative easing” (known as printing money to you and me). What happens within the eurozone will, in this context, be fascinating – who will support the Germans in arguing that monetary policy should remain relatively tight?  What happens if the Germans lose this argument at the level of the European Central Bank’s Governing Council?

In any case, the Fed’s move pushes us in the definite direction of higher global inflation.  This is better than the alternative of falling wages and prices, but it comes with risks.  Will we be able to control this inflation now or in the near future?  What are the consequences of inflation during a severe global recession – which seems unavoidable, even if the Obama Administration has all possible dimensions of expansionary policy firing on all cyclinders right away (this was the point in our latest baseline scenario).

8 responses to “Expansionary Monetary Policy is Infectious

  1. Pingback: Real Time Economics : Secondary Sources: Fed, Fed and More Fed

  2. Darrel Delamaide in MarketWatch discusses the need to reflate the economy and refers to Simon Johnson as one of the few economists to publicly call for this: “When 0% Isn’t Low Enough; Should the Obama Team Embrace Inflation?”.

    URL: http://baselinescenario.com/2008/12/17/expansionary-monetary-policy-is-infectious/

  3. Sorry, but deflation and falling prices in this case are strictly driven by the unwinding of the commodities bubble. Look at core prices – they were flat in the last reading.

    Have you noticed that when prices of gas were skyrocketing, you only heard about core inflation (minus food and energy), but now that prices are falling, the headlines show consumer prices which include food and energy?

    Right now, all of the money ($2 trillion) that the Fed has printed has not made it to the system yet. It is still being hoarded by banks. But once they start lending it out or it does make it’s way to the consumer we will see massive inflation. Also, if China funds it’s own bailout projects with it’s $4 trillion in US dollars, we could see the collapse of the dollar.

    Inflation is not a good thing, however we have been conditioned to think it is a necessary evil. The only beneficiary of inflation is the Federal Government because they can fund all their programs without raising taxes. During the Industrial Revolution we had massive deflation and it was the most productive time in our history.

    Please read the first part of Crash Proof by Peter Schiff and listen to the lecture “the Creature from Jekyll Island” on Google. It will expose our banking system for the scam it really is.

  4. Mark A. Sadowski

    bevans623,
    Although core consumer prices held steady last month they actually fell the previous month.

    The unwinding of the commodities bubble is not a trivial thing. Just as economists were concerned about the effect on core inflation, now they are worried about the effect on core deflation.

    And I wouldn’t worry about the run-up in the monetary base. Japan has more than doubled the monetary base since 1994 and the result has been 14 years of deflation. Similarly the United States increased the monetary base fivefold between 1929 and 1944 and prices were flat. Banks are very illiquid right now and furthermore there are no good lending opportunities when the economy is in a free fall. If and when things turn around the Fed should easily be able to mop up the liquidity. And China is held hostage by their own dollars. They can’t risk depreciating the dollar without cutting their own throats.

    Your statement about the industrial revolution is however was what I disagree with most. Fortunately we have a fair amount of data for both the United States and the United Kingdom. The dates for the industrial revolution vary but it is generally considered to start in the late 18th century. The Second Industrial Revolution is generally considered to run from 1870-1914.

    The United States had five major deflations between 1790 and 1914: 1801-1802, 1814-1821, 1822-1824, 1841-1843, and 1865-1878. Four of these are associated with “panics”: the Panic of 1819, the Panic of 1837, and the Panic of 1873. The average rate of real GDP per capita growth during these five deflations was the following (ordered sequentially): 0.0%, -0.4%, 1.8%, 1.1% and 1.0%. The average rate of real GDP per capita growth during those 25 years was 0.6%. The average rate of real GDP per capita growth during the other 99 years was 1.6%. Average real GDP per capita growth has been higher since 1914 so I’m not sure I would call it our most productive time but clearly the best years of the Industrial Revolution were not during the deflations.

    A similar thing applies to the United Kingdom. There were four major deflations between 1830 and 1914 (that’s all the data we have): 1830-1833, 1839-1843, 1847-1852 and 1873-1880. Average real GDP per capita growth was the following during these four periods: 0.4%, -2.0%, 2.2% and 0.6%. The average rate of real GDP per capita growth during the 19 years of deflation was 0.0%. During the remaining 65 other years average real GDP per capita growth was 1.5%. In other words all of the growth in GDP per capita in the United Kingdom during the Industrial Revolution occurred during the years when there was no deflation.

    The 1830′s and 1840′s in the United Kingdom were hard times with real wages essentially flat (provided you actually could find a job). To get an idea of what life was like all you have to do is read a Dickens novel like A Christmas Story or Oliver Twist. And the period after the Panic of 1873 was known as the Long Depression when manufacturing and construction literally ground to a halt in the United States and Europe. It was the time in the US when the words “bum” and “tramp” came into vogue because there were so many of them. Deflations are never good times.

    And please don’t tell me you like Peter Schiff. His criticism of the banking system may ring true but on many things he is absolutely wrong. He has given poor stock investment advice for years. The only thing he has been right about is gold but the rally in gold peaked in March and if you’re still holding on to it you’ve lost 15% since then. He is an Austrian School groupie and doesn’t know much about economics. All of his predictions about inflation for the last half of this year have been terrible.

  5. Mark A. Sadowski

    Sorry, a slight exageration on the UK data. Average real GDP growth per capita during the 19 years of deflation was 0.4% not 0.0%. And average real GDP per capita growth during the other 65 years was 1.4% not 1.5%. Actually this is interestingly similar to the US data.

  6. Mark A. Sadowski

    Another error. The Dickens story is of course called A Christmas Carol, not A Christmas Story. Merry Christmas by the way!

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