Wednesday, March 12, 2008

Intertemporal macroeconomic tradeoffs

The US Federal Reserve is keeping interest rates low to limit the possible extent of a US downturn or recession. Housing prices are collapsing and credit markets are imploding in the US. Fears of resurgent inflation - currently running at 4% in the US economy - are set to one side by US policy-makers on the grounds that the enormous commodity price hikes of between 20-50% are once-and-for-all price changes that need not become inflation.

That is probably an optimistic illusion given the high growth rates in monetary aggregates now occurring.

Ken Rogoff argues that these price hikes are indeed likely to become inflationary and that the cost of moderating the current downturn will be an inflationary surge that will last for years. A difficulty is that a range of foreign currencies are effectively pegged in value to the US dollar. When the US cuts its interest rates these economies face pressures to cut their own - otherwise induced capital inflows will drive up the value of their currencies making it harder for them to export. This creates a basis for an inflationary spiral in much (perhaps 60%) of the world economy.

Paradoxically this inflation problem will be worse if the US recession is mild - because current policy works - rather than a deep, prolonged downturn. Then the implied global contraction will not be strong enough to induce a fall in global commodity prices and as a means for tempering global aggregate demand.

The short-term gains from seeking to avoid recession by flooding the US economy with liquidity now need to be assessed against the costs of the longer-term global inflation that will develop with some ferocity particularly if the short-term policy is effective. It is an intertemporal policy tradeoff.

Australia does not as yet need to address problems associated with collapsing property markets and imploding credit markets. The RBA has accordingly stuck to its central objective of avoiding inflation and maintaining its credibility of dealing with inflation. Interest rates are much higher than those in the US so that the Australian dollar will tend to remain strong even should commodity prices weaken somewhat.

Australian policy-makers face simpler tradeoff issues than do those in the US since we do not face an immediate need to stimulate the economy. Indeed as Australia is, to the contrary, enjoying the biggest investment boom for 18 years the policy objective of targeting inflation reduces demand pressures generally in the economy - the only fear here is damage to the investment boom itself which could damage the economy's future productive capacity. Ignoring the latter fear Australia can therefore sensibly pay more attention to longer-term inflation issues.

Moreover, should the expansionary US policies fail to work so the world economy moves into recession it is straightforward for Australia to cut interest rates and reverse the current policy stance. If the US policies do work and inflation is strongly invigorated we can perservere with current policies for a time to make sure than we live longer-term with lower rates of inflation than will be experienced elsewhere.

Rough, provisional ideas - comments welcome.


Hat-tip for the Rogoff paper to Gregory Mankiw.

5 comments:

Anonymous said...

Harry:
It's the 70's all over again, or so it seems. Let's hope for our sake that china keeps the peg for as long as possible so we enjoy the good times because the moment they let the Yuan go, it's all over.

Gold is telling us that the US is reflating big time.
But they have no choice. It's either screw creditor or screw the debtor and a central bank will always screw the lender through inflation when the chips are down

One group that runs counter to that is Bank Credit Analyst, which I subscribe to. They argue that the blip up in the US CPI will moderate in the next few months as the economy slows down. Interestingly they only see a shallow recession.

All in all the Fed better be ready to hike rates once the economy picks up otherwise they'll start this again.

The fed's action last night may have actually broken the downswing in the stockmarket as they're now willing to take on 200 billion of those mortgages through the fed window. The rally of just under 5% was very impressive. Interestingly gold didn't rally on that news.

This is the first time I have ever seen the Fed intervene on the asset side of banks balance sheets. First-rate bank stocks (if there is such a thing) are now stating to look good again in the US. There are some terrific brand names that may do ok. Morgan Stanley, Merrill Lynch, JP Morgan and even Citibank if it is not too permanently damaged.

Watch the US bank stocks to see if things turn around.

One stock the street uses as a proxy for both the world and US economy is Caterpillar Inc. as it has huge lead and lag times. Interestingly although the stock is down, it is not down a enough to convey very bad times ahead. It’s actually just indicating a shallow and quick ending recession.

conrad said...

As questions of interest that you might be able to answer, I have noticed that as soon as the US puts its interest rates down, the price of generally imported commodities simply goes up (very quickly in the case of oil and gold). I'm just wondering what percentage of costs US companies/consumers are saving in interests rates is simply being taken back by higher prices of essential imported commodities when the interest rates move?

Anonymous said...

The local situation looks a lot like 1972: high employment, emerging inflation, high commodity prices producing a strong exchange rate.

The sub prime crisis might even be interpreted as a bad supply side shock, like the oil shocks of around that time.

The difference now is that the RBA has the policy instruments to combat the inflation problem, there's no sign of any weakening of government finances and the economy is a lot more resilient.

We'll probably get out of it with a mild slow down not a recession, but I wouldn't want to bet my house on it.

Uncle Milton

Anonymous said...

what a load of cobblers.

A credit cruch by definition is deflationary. Bernanke has talked about this. Inflation is yesterday's news.

In the 70's labour markets around the world were a lot more regulated than now. so inflation was easier to transmit.

Wages are not a problem here nor in the US and won't be. They would have been so before this if they were.

Inflation in Australia is about pricing power of producers which will dissipate as the economy slows.

The Fed has been too slow to get to a cash rate of 1%. It needs a shrply steepend yield curve from 0-3 years to ensure quick profitability of banks.

The other thing is that the market these days is filled with inexperienced people who are scared.

Why would the market be thinking Australia or Norway could default on their bonds.

hc said...

Could I request commentors to identify themselves or use identifiable pseudonymns if they wish to remain anonymous in posting?