WSJ Editorial: Is the Fed finally waking up to inflation threat

Isn't it sad when the WSJ editorial page has more credibility than Paul Krugman who recently argued that we didn't have to worry about inflation? -- What breakfast has he been eating? --RB

REVIEW & OUTLOOK



The Buck Stops Where?
June 5, 2008; Page A20

When Paul Volcker declared several weeks ago that the world was in a "dollar crisis," his successors at the Federal Reserve made their private disapproval very clear. This week current Fed Chairman Ben Bernanke waved the white flag over Mr. Volcker's point by declaring his own public concern "that the dollar remains a strong and stable currency." Apologies accepted, provisionally.

The tragedy is that this is big news. The Fed has monopoly power over dollar creation, and concern for its value ought to go without saying. Yet so great has been the Fed's dollar abdication in recent years, and especially since last summer, that Mr. Bernanke's words have come as a great global relief. As the dollar has strengthened in welcome response, the price of gold and oil has fallen in each of the last two days.

The question now is whether the Fed will follow up its new words with action. "We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations," Mr. Bernanke said on Tuesday, a sign that the Fed may be waking up to the inflation threat. But the Fed chief also signaled that he isn't about to tighten monetary policy any time soon because current "policy seems well positioned to promote moderate growth and price stability over time."

Price stability where? Not in the U.S., where every economic report shows rising price pressure. Yesterday the feds reported that labor compensation rose at a healthy 4.9% for the first quarter, but only 0.6% after inflation. The Fed-inspired commodity boom has sent food and energy prices soaring, while wage gains invariably lag. If Republicans want to know why voters are so upset about an economy with a jobless rate of 5% – below the 5.2% rate when Bill Clinton won re-election in 1996 – this erosion of real incomes is the reason.

The Bernanke Fed has also been oblivious to the fact that it runs a global dollar bloc. Central banks in dozens of countries peg or otherwise link their own currencies to the world's reserve currency, which is the dollar. They do so for the sake of exchange-rate stability, which helps with trade and investment flows. They essentially subcontract their monetary policy to the U.S. central bank.

The Fed's dollar indifference has sent an inflation shock through those dollar-linked economies. This week alone, we've read about price riots in Vietnam; inflation hitting 10.1% in Kuwait; Abu Dhabi contemplating price or wage controls; South Korean and Indonesian central bankers considering rate hikes; and the Chinese letting the yuan rise ever higher to curb inflationary pressures imported from the U.S.

Many of these countries are now delinking from the greenback. Meanwhile, the dollar plunge has translated into a net transfer of trillions in wealth from the U.S. to the rest of the world. The result has been the largest decline in America's global economic influence since the 1970s.

It will take more than a single speech from Mr. Bernanke to undo this damage. A statement of support for the strong dollar from both the Treasury and President Bush would certainly help. The last time Mr. Bush dared to speak his mind this way, in March, Treasury quickly hushed him up. Now would be a good time for the President to say he agrees with what Mr. Bernanke said this week.

The business press has been chattering about Treasury "intervention" in the foreign exchange markets, but this would mostly be symbolic action to scare currency traders. Such interventions are invariably "sterilized," meaning that central banks are careful not to increase or decrease the net supply of dollars. Changing the value of the dollar means reducing the supply of, or increasing the demand for, dollars. At the current moment, the world isn't likely to demand more dollars until it concludes that the Fed is serious about stopping the greenback's further decline.

In this context, last week's announcement of the August departure of Fed Governor Frederic Mishkin is good news. Mr. Mishkin is one of the intellectual architects of the Fed's dollar debacle. His departure means the Fed will soon have three of seven seats unfilled, with one more Governor unconfirmed. The Senate seems disinclined to confirm any more Bush nominees, and that may be just as well. The next President deserves a chance to remake the Fed with sound-money appointees. This Administration has named too many academics who know a lot about monetary theory but too little about currency markets and price signals in the real world.
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The best news would be if this week marks a turning point at the Fed and at the Treasury. The leaders of those institutions have justified the Fed's sprint down the interest-rate curve as a way to boost exports, rescue the financial system and prevent a recession. They were wrong.

What has spared Wall Street more pain is the Fed's decision to open the discount window wider and to more borrowers. The easy-money experiment has merely hit consumers and the already struggling economy with a commodity price wallop, while inspiring a global flight from dollar assets. It's time to start acting to repair the damage.

WSJ: Martin Feldstein: Enough With the Interest Rate Cuts

Wall Street Journal

OPINION


DOW JONES REPRINTS


Enough With the Interest Rate Cuts
By MARTIN FELDSTEIN
April 15, 2008; Page A19

It's time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage.

Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries. In order to offset the inflationary impact of higher imported commodity prices, central banks in those countries may raise interest rates. Such contractionary policies would reduce real incomes and exacerbate political instability.

The impact of low interest rates on commodity-price inflation is different from the traditional inflationary effect of easy money. The usual concern is that lowering interest rates stimulates economic activity to a point at which labor and product markets cause wages and prices to rise. That is unlikely to happen in the U.S. in the coming year. The general weakness of the economy will keep most wages and prices from rising more rapidly.

But high unemployment and low capacity utilization would not prevent lower interest rates from driving up commodity prices. Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates also add to the upward pressure on these commodity prices – by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains.

Lower interest rates induce investors to add commodities to their portfolios. When rates are low, portfolio investors will bid up the prices of oil and other commodities to levels at which the expected future returns are in line with the lower rates.

An interest rate-induced rise in the price of oil also contributes indirectly to higher prices of food grains. It does so by making it profitable for farmers to devote more farm land to growing corn for ethanol. The resulting reduction in acreage devoted to producing food crops causes the supply of those commodities to decline and their prices to rise.

Rising food and energy prices can contribute significantly to the inflation rate and the cost of living in the U.S. The 25% weight of food and energy in the U.S. consumer price index means that a 10% rise in the prices of food and energy adds 2.5% to the overall price level. Commodity price inflation is of particular concern now that the CPI has increased 4% in the past 12 months. Surveys indicate that households are expecting a 4.8% rise in the coming year.

In lower-income, emerging-market countries, food and energy are generally a larger part of consumer spending. A rise in these commodity prices can therefore add proportionally more to the cost of living in those countries, and therefore depress real incomes to a greater extent than in the U.S.

Government actions to dilute these effects by increased subsidies on the prices of energy and food add to the government deficits, reducing the national saving available for investment in plant and equipment that would otherwise contribute to faster economic growth.

The rise in the U.S. inflation rate, and the adverse effects in emerging market countries, might be defensible if lower interest rates could significantly stimulate demand and reduce the risk of a deep recession. But under current conditions, reducing the federal funds interest rate from the current 2.25% by 50 or 75 basis points is not likely to do much to stimulate demand.

The current conditions in the housing industry and in credit markets mean that a further lowering of interest rates will have a smaller impact on demand than in previous recessions. In previous recessions, lower rates stimulated aggregate demand by inducing increased home building. But with the massive inventory of unsold homes – up 50% from a few years ago – a further cut in the fed funds rate would have little effect on housing construction.

Moreover, lowering the fed funds rate has not brought down mortgage interest rates. While the fed funds rate is down three percentage points from this time last year, mortgage interest rates are down by less than 0.5 percentage points.

The dysfunctional state of the credit market means that many individuals and businesses are unable to get credit. Lowering interest rates will not stimulate demand for those who cannot get credit.

Economic recovery will require resolving the difficult problems of the credit markets, dealing with the millions of homeowners who may now be tempted to default on mortgages that exceed the value of their homes, and reducing the risk that the ongoing decline in house prices will push millions of additional homeowners into a vulnerable, negative equity condition. A lower fed funds rate will not solve any of those problems.

Mr. Feldstein, chairman of the Council of Economic Advisers under President Reagan, is a professor at Harvard and a member of The Wall Street Journal's board of contributors.

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