Market to Fed: Wake Up!
June 26, 2008
My first reaction to yesterday’s FOMC statement, laid out in Fed Mum This Time on Dollar, was that an opportunity had been dropped to reinforce the new U.S. policy sensitivity to dollar depreciation. Monetary policy controls the supply-side of money, which must be aligned to demand to safeguard the internal value of that money (measured by inflation) and its external value, which can be gauged by the exchange rate. The Fed met this week against the backdrop of a fragile dollar, unacceptably high U.S. inflation, soaring global inflation, and evidence of rising expected inflation in many countries including the United States. Growth risks remain skewed to the downside, but there still has been not a single quarter of negative U.S. growth. Moreover, the biggest recent drags on growth are posed by soaring commodity costs and higher expected inflation. At first, lower U.S. central bank rates made sense, but a point was crossed quite a while ago where risks to growth have been fanned, not mitigated, by the Fed’s very accommodative monetary policy. It’s not enough to stop cutting the 2.0% Fed funds rate, which is half the going on-year rate of CPI inflation. Yesterday’s whole Fed package of leaving rates unchanged and releasing a statement that balanced rising price risks against remaining growth risks while saying absolutely nothing about the dollar had the net effect of darkening the outlooks for both inflation and growth.
Market movements today endorse this view: oil and gold are sharply higher, and the dollar is weaker. Since lows yesterday, the dollar has climbed more than 1.0% against both the euro and yen. From closings yesterday, oil has risen 2.6%, and gold has advanced 3.5%. Both of those commodities are over 5.0% higher than June 10th closing levels. The Wall Street Journal and Financial Times ran critical lead editorials, which along with my post yesterday foretell today’s disappointing market reaction. The Journal maintains that “the Fed has failed in its main responsibility of maintaining price stability and a stable dollar.” The FT proclaims, “Fed cannot ignore global inflation.” Their point is that Asian nations with currencies that are pegged to the dollar enforce those pegs by tying their interest rate policies to Fed policy. The reduced Fed funds rate from 5.25% early last September to 2.0% now has caused Asian monetary policies to become ridiculously stimulative in a region that has been overheating for years. The predictable result has been a steep climb in commodity prices, a weaker dollar, and slumping consumer sentiment around the world including in the United States. It’s the U.S. Treasury’s job to encourage Asian emerging markets to let their currencies float more freely, meaning upward. But until those efforts are successful, the Fed has to deal with the current reality. The Fed’s policy against this backdrop is not an effective way to anchor domestic or world price expectations.
In 1974, the world economy faced both recession and a commodity-intensive surge of inflation. Japanese CPI was up over 20% that year, and U.S. inflation ended the year at 12.2%. Central banks in those countries in perhaps the biggest economic blunder of the last half-century addressed the risk to growth, just as the Fed is doing now. Growth resumed, and inflation settled back to 7.6% in Japan by end-1975 and 4.8% in the U.S. by end-1976. Japanese inflation was back at 10.4% by end-1976, and U.S. inflation peaked above 14% in early 1980. Paul Volcker, who slayed the dragon back then but not without enormous pain and suffering, is worried about world economic policy trends now. So am I.
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