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).