FT columnist Martin Wolf argues that the Fed can’t ignore the risk of inflation as it fights recession. It says:

To critics it is now the “Bernanke put” – the belief that, as under Alan Greenspan, the US Federal Reserve will always ride to the rescue of Wall Street. The jubilant response of traders to the Fed’s 50 basis point cut in the short-term interest rate might justify this suspicion. But saving Wall Street from its follies is not the Fed’s objective. It is an (unfortunate) by-product of the attempt to do its job.

The “unfortunate by-product” reference is similar to Alan Greenspan’s reply to Jon Stewart on the Daily Show. Stewart asked Greenspan why it was that the Fed 50 basis point interest rate cut sent the stock market up over 300 point, thus benefitting the rich, while it meant that banks would pay less interest to the ordinary people who had savings accounts in banks, rather than stock market investments. Greenspan responded that this was an “unintended effect.”

I agree with Wolf that one inflationary risk the US runs is that the dollar’s value will decline against other currencies (as it has already), thus making everything imported more expensive. However, inflation is the easiest way for debtor nations to try to get out from under their debts; as the dollar’s value decreases, the absolute value of the debt decreases, too. So, you pay off your debt in cheaper dollars. This is usually only attempted by pariah states, currently Zimbabwe comes to mind, but George Bush has such contempt for the international community that it is not beyond possibility that he will try it. He may think it will help him pay off his Iraq War debt. As Wolf describes the situation:

Externally, the US is a huge net debtor. A large dollar devaluation is then a far less painful way to turn it into a net creditor than running current account surpluses, since its liabilities are denominated in dollars.

Given these facts, it is going to be an enduring struggle for the Fed to convince those who have put their faith in the dollar that it is safe. This is not some remote danger. In financial markets, the future is now. If holders of the dollar conclude it is no longer a secure store of value they will dump both the currency and assets dependent on its future value. If that were to happen, the Fed would confront a dreadful dilemma – whether or not to cut rates as the dollar plunged and long-term interest rates soared. Its freedom of manoeuvre would be gone, as in 1979, when Paul Volcker became chairman.

In retrospect it looks as if Volker may have been a better Fed chairman than Greenspan, if only because Volker had more difficult issues to deal with.

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