"The Committee expected inflation to moderate later this year and next. However, in light of the continued increases in the prices of energy and some other commodities and the elevated state of some indicators of inflation expectations, uncertainty about the inflation outlook remained high. The Committee stated that the substantial easing of monetary policy to date, combined with ongoing measures to foster market liquidity, should help promote moderate growth over time. Although downside risks to growth remained, they appeared to have diminished somewhat, and the upside risks to inflation and inflation expectations increased."
WTF? As of just last month, the Fed assessed the situation and thinks downside risks to growth have "diminished" while risks to inflation "increased". What are they drinking at these meetings? I am up in arms about this because even undergrad econ majors can recognize this disconnect. You see, inflation is a monetary phenomenon. That means it is when too many units of currency (dollars) chase the same amount of goods and services. If there are only $1000 dollars in the world and two goods (picture a simple deserted island), they are going to cost $500 each. If there is only $100 on the island, the goods will cost $50 each. Money per unit of stuff. Create money faster than creating stuff and you have the recipe for inflation.
Now for the disconnect: there is less money now than last year. That's what happens with the financial system delevers because of losses. Not only are the capital reserves absorbing losses, but they must be replaced from money that otherwise would have bought stuff. In addition, if reserves can't be maintained, assets (loans) must be sold or cashed out at a 10:1 rate. In short, there is a massive destruction of money going on- not rampant creation of money that fueled '70s style inflation. Ughh.
Someone might contort an explanation why my last paragraph is wrong (although I doubt it since housing and stocks- the two biggest assets on the country's balance sheet- are deflating!), they still should have noticed the peaking and subsequent fall in commodity prices. In fairness, as of 8/5 this wasn't entirely clear, but it will be by next week's meeting. Even so, how could they arrive at the conclusion that downside risks to growth have "diminished"? The credit crisis in still in full roar and unemployment is rising faster than expected.
Let's award The Long Run Blog's first "Economic Idiot of the Week/Month/Year/TBD". This post's award goes to Mr. Richard Fisher, President of the Federal Reserve Bank of Dallas for his voting to increase interest rates and tighten monetary policy. As discussed in the minutes:
Mr. Fisher dissented because he favored an increase in the target federal funds rate to help restrain inflation and inflation expectations, which were at risk of drifting higher. While the financial system remained fragile and economic growth was sluggish and could weaken further, he saw a greater risk to the economy from upward pressures on inflation. In his view, businesses had become more inclined to raise prices to pass on the higher costs of imported goods and higher energy costs, the latter of which were well above their levels of late 2007. Accordingly, he supported a policy tightening at this meeting.
Yes, clearly the wise policy would be to tighten monetary policy when the financial system is in a credit CRUNCH, meaning there isn't much credit to be had or created due to the losses. Has this man had any economic training? At least Big Ben has studied the Depression in depth and knows not to repeat this mistake.
In fairness, I wholly support a diverse representation of thoughts on the Committee. Group think is not a good thing; however such idiotic reasoning is probably nothing but counterproductive.
"Economic Idiot of the Week" was inspired by the Geologic Podcast.
ReplyDeleteGreat question. Inflation is when the general price level rises because there is more money chasing a set of goods/services. So, if you create an additional 15% more money each year, but the amount of actual economic activity rises by say 5%, then generally prices will rise to reflect too much money per unit of economic output. For example, take an island economy where I cut down coconuts and you cut firewood. If we use shells as money and each month we find more shells but our coconut and firewood output is the same, we will each demand more shells in exchange for the same amount of stuff- i.e. inflation. If we have a fixed amount of shells, then the general level of prices will stay the same.
ReplyDeleteNow, let's say there is one bank in the economy and it has $100 of capital and $1000 of loans or 10:1 leverage. Some loans go bad, say $50 worth. Now the bank has loans of $950, capital of just $50. $950/$50 is 19:1 leverage which we don't allow, so either the bank must raise $45 or sell off $450 in loans. In our one bank economy, there was $1000 of money. Now there is $950 (money was destroyed), but we're not done yet- the bank needs to either unwind $450 in loans or raise $45 in capital. The $45 would have supported another $450 in loans (total money supply of $1450) had there not been losses. Instead, the $45 must come from money that otherwise would have gone elsewhere, slowing down the velocity or multiplier effect. The net result is our one bank economy went from $1000 of money to $950 in money. How can we have inflation when there is less money per the same amount of stuff?
ReplyDeleteSo the reason you believe Richard Fisher to be an Economic Idiot is because he wants to raise interest rates which will essentially prevent (in our one bank example) that bank from raising the additional $45 in capital.
ReplyDeleteSort of. He wants to raise interest rates to fight the potential for inflation that can't happen based on backward looking data. If he did raise rates, it would further hurt the mortgage market, further hurt the banks ability to rebuild capital, further hurt business and consumer credit access and generally destroy the economy.
ReplyDeleteA reader commented to me that calling Fisher the idiot of the week for voting to raise rates may be misplaced. Their point was that in a credit crisis, raising rates has little effect since it is the availability of funds that makes the difference rather than the price (within reason) of those funds. In other words, it doesn't matter whether the price is 1%, 2% or 3%, banks still need to borrow to improve their balance sheets. It follows that if raising rates will not hurt the crisis, then Fisher is not an idiot for suggesting to raise rates. And they have a point. However, I maintain that focusing on inflation, a problem which is about to disappear and become a deflationary problem, is still a very misguided stance for a Fed president to take at this time. The Fed should be seeking to inspire confidence in their decision making, rather than spending time publicly fighting last year's battle. Perhaps more importantly, this illustrates how details, nuances and views can legitimately differ without anyone being outright wrong. Welcome to economics, the world of imperfect information and endless opinion.
ReplyDelete