2008 June 14 Saturday
High Commodity Prices Might Cause Stagflation

Countries that maintain dollar pegs with their currencies must relax monetary policy when the US Federal Reserve relaxes monetary policy. Otherwise their currencies would rise against the dollar. Well, the Fed relaxed monetary policy in 2007 and into 2008 in order to prevent the popping of the housing bubble from causing a recession. But East Asian countries relaxed their currencies too. This sped up the growth rate of their demand for commodities and in doing so contributed to the rise in commodity prices. The rise in commodity prices pushes up prices over a large range of goods and services and could force the Fed to raise interest rates even as unemployment rises.

"The important thing to recognize is that we are more interconnected financially with the rest of the world," says Tim Duy, an economist at the University of Oregon in Eugene. "The expectation ... was that oil prices were going to go down" as the US economy slowed, but that didn't happen, he says.

One reason is simply that the US, while still by far the world's largest single economy, is now counterbalanced somewhat by fast-rising emerging nations. Their continued strength has buoyed both the global economy and commodity prices.

But Mr. Duy says that another factor may be at work – an unintended consequence of the Fed's recent interest-rate cuts.

When the Fed eases monetary policy to stimulate growth at home, other nations with currencies pegged to the dollar also have to ease their monetary conditions in order to maintain their exchange rates. The result is more money in the global system, which translates into more upward pressure on oil, food, and other prices.

"That linkage of domestic policy having global impact [and then rippling back into US consumer prices] is new for the Federal Reserve," Duy says. "If it is true, I think it does represent a significant change."

The inflation rate is already higher than the Fed acknowledges.

Some argue that inflation is not out of control.

Nor has inflation spread across the rest of the economy. The core rate, which excludes food and energy, has been eerily consistent for a long time. In April, the annual core inflation rate was 2.3 percent higher than a year before. In April 2007, it was up 2.4 percent. In April 2006, 2.3 percent. A year before that, 2.2 percent.

I see two flaws in this argument. First off, the focus on "core inflation" is suspect since people spend real money on food and fuel. Second, rising commodity prices have squeezed producer profits and their input costs have gotten high enough that they are starting to pass along more costs.

Prices are 4.2% higher than a year ago. That is a substantial rate of inflation. The Fed has put other priorities ahead of price stability.

On an annual basis, inflation worsened for the first time in four months, running at 4.2 percent in May compared with a year ago.

The index, which rose more than economists had forecast, comes on the heels of repeated warnings about inflation from the world’s central banks. The chairman of the Fed, Ben S. Bernanke, joined other bank officials this week in focusing on higher prices, citing the economic damage wrought by the record run-up in food and oil prices.

Since the causes of inflation are worldwide only a worldwide recession will put a damper on inflation.

Share |      By Randall Parker at 2008 June 14 12:36 AM  Economics Trade


Comments
Kenelm Digby said at June 14, 2008 4:47 AM:

Really there are only two economic 'blocs' in the World these days:
1/. China and the countries that export to China.
2/. The rest.

China is, of course, still doing fabuolously well with growth rates of 10% per annum.The nations that supply it with commodities and oil (eg Russia, the Gulf States, Australia etc - and perhaps Germany for machinery),are also doing very well.
The 'rest', being drained of money stock by the 'China monster'can sit and twiddle their thumbs whilst slowly sliding into destitution.

averros said at June 14, 2008 6:35 PM:

> The Fed has put other priorities ahead of price stability.

The Fed never has price stability as priority, precisely because it is Fed's unceasing emission of fiat money which causes inflation in the first place. The money is emitted in form of inter-bank ("prime") loans, which is what Fed is doing when it sets the "prime rate" - the way it effects its setting of the rate is creation of fictitious money which it then "loans" at the set rate.

When you have hard money which cannot be easily created in arbitrary quantities, the natural trend for prices is to go down, tracking the increase in productivity due to technological progress. Wages are stable under the hard money because decline in revenues caused by lowering prices is compensated by increased per-worker productivity.

The only discernible function Fed has is to transfer wealth from poor and middle class to the bankers by the age-old trick of gradual debasement of currency (figuring out why creation of money at some place and letting that money to dissipate over the whole economy is equivalent to transfer of wealth to that place is left as an excercize to the reader). So its only priority is prolongation of its ability to run this scam - the ability depending on keeping the lid on destructive effects of this transfer, since a collapse of US economy would likely cause forceful removal of the ruling clique from power (and I don't mean the US Govt).


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