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29 March 2024

Bernanke chases his tail after spraying cheap money around

Published
By Julian Bene

Having rescued the financial system by spraying cheap money around, the Federal Reserve is now either relieved that the economy has squeaked through relatively unscathed or the central bank is caught in a bind. Take your pick.

So far there has been no steep downturn in spending, nor has there been a spate of corporate bankruptcies. However, the dollar is weaker than ever and inflation is threatening to pick up, both as Economics 101 would predict from ultra-low interest rates. So Fed Chairman Ben Bernanke and Vice-Chairman Donald Kohn have been making speeches with a strong emphasis on the need to head off inflationary expectations as well as references to the importance of the dollar's value.

The weak dollar is part of the cause of inflation. It is in turn partially the result of interest rates that are lower than those obtainable in Europe and the United Kingdom. The other big dollar factor is the continuing massive trade gap. Those net outflows of dollars have to take their toll on the greenback's worth in other currencies. Letting interest rates rise would help strengthen the dollar. But it is not as if the US economy is over-heating in a classically inflationary way that calls for monetary tightening. It seems a fair bet that the housing debacle will continue to hang over the economy for at least 18 months.

The US inflationary pressures, other than those from the weak dollar putting upward torque on import prices, are due to commodity prices that seem to be spiralling because of growing demand from China and India colliding with fairly fixed supply. Tighter money in the US economy might only address that problem if it were draconian enough to cause a steep domestic downturn, and probably one that flipped those two big Asian exporters into downturns of their own. It could come to that, but nobody much would be cheering for such an outcome, which would be global recession or worse.

There is another possible impact of easy money on global commodity prices, via everyone's favourite demons, the speculators. Congress is trying to show its mettle by demanding investigations into whether financial players are behind the rapid run-ups in oil and other prices. And it is certainly true that all that cheap money has to find its way somewhere.

Now that property has fallen out of favour as a place to make a quick buck, it is not so far-fetched to expect that some of the futures market action in commodities is propelled by overly abundant cash. Those cries of hurt innocence from the hedge funds do not ring as true as the argument that these price rises reflect the fundamental crunch of growing demand from the industrialising and increasingly prosperous Asian giants up against fairly fixed supply.

We are probably going to have to get used to expensive commodities, since the price mechanism is the only way the market knows how to allocate scarce resources. That might work reasonably to adjust consumption patterns of those who live well above subsistence levels. But it is undoubtedly cruel to the poorest among us. Unless the commodity-rich winners generously choose to compensate deserving losers, there will likely be much suffering in the worst-off regions of the world. This looks like a problem that has been half a century in the making, with exponential population growth and rapid productivity growth.

Returning to relatively banal questions of short-term economic policy, does the change of rhetorical emphasis towards inflation from the Fed leadership mean that Fed chairman Bernanke was wrong to slash rates from 5.25 to 2 per cent when the mortgage crisis hit? The Wall Street Journal editorial board seems to have decided in that direction, sneering recently about stagflation that it attributes to the Fed's low-rates policy. Yet banks and consumers alike would be in deep trouble if the Fed had let the credit mess run its course. Surely if the Fed had stood pat on interest rates we would be in a very deep recession by now, hardly in the best interests of the Journal's readers and advertisers. Have Murdoch's new minions (the Australian media mogul recently grabbed the venerable New York business organ for his empire) such short memories that they now discount the sub-prime panic?

An alternative interpretation might be that Bernanke is bluffing about interest rates and hoping that he can control those ever-worrying price expectations simply by wagging his finger. Can he afford to raise rates and take a risk of plunging the economy into a downturn?

Well, he must take some comfort from the fact that Americans are still spending. Retail sales in May were up, and not just because petrol prices have rocketed and Americans are incapable of cutting back on their driving. Even excluding petrol, retail spending rose by a relatively striking 0.8 per cent for the month. Where do Americans find the money? One answer is those tax rebate cheques that the politicians kindly arranged to have sent out to many of them last month. Like the happy spenders they are, they seem to have run out and spent those cheques as fast as they cleared. Since the rebates are a one-time only event, their effect will have vanished come July, so the Fed must be factoring them out of their growth calculations.

On the less comforting side, unemployment jumped to 5.5 per cent. The surprise, given the huge slowdown in real estate, is that the jobless rate has taken so long to reflect any real pain. Even so, apologists have been busily pointing out that May unemployment rate figures are always an aberration because that is the month when large numbers of high school and college graduates show up looking for work for the first time, after school finishes. Another way of looking at it is to recall that unemployment numbers exclude "discouraged workers." The youngsters coming on to the labour market for the first time have not had a chance to be discouraged by the state of the job offers. That could change in a hurry if the economy slides.

Yet, for all that the jobs picture in the United States is a little gloomy, a spike to 5.5 per cent unemployment is not the sort of wrenching move that seems likely to twist another down spiral out of the housing market. If really big numbers of people lost jobs, they would add considerably to mortgage defaults and eventually to the inventory overhang in housing. So far, that nightmare for policymakers has not materialised.

But the vaunted trade turnaround that was supposed to rescue the US economy has not materialised either. The latest US trade gap was another whopper. Exports were up a bit, which is good for jobs in that sector as far as it goes, but imports soared much more. The leading import factor was the skyward direction of oil prices. If Americans cannot discipline themselves to cut back on the gallons of petrol and jet fuel that they guzzle, and it seems they cannot in the short term, the result has soon to be lower spending on other stuff, including stuff that Americans make and sell. In other words, whether the rocketing price of a barrel of crude bleeds into general inflation or not, it is likely to bleed American jobs.

The higher oil price is like an income tax, drawing demand out of the economy. Unless oil exporters and the Chinese drastically change their ways and start using their burgeoning revenues and reserves to buy far more American (and / or European) exports than has been the case this past few years, the global economic music seems likely to stop.

After all, we have sat through the movies where Americans borrow dollars back from the Chinese and Saudis, recycling those nations' massive trade surpluses, and go on a debt-fuelled consumption binge. The best known of those movies was called "Sub-Prime". Nobody much liked the ending. "Sub-Prime 2 – the Sequel" seems unlikely to appeal to the studio chiefs in Washington and New York. Or to put it in boring old econo-speak, foreign exchange imbalances like these are simply not sustainable.

An interesting war of words broke out between US and Chinese economic leaders recently that suggests both that the tension about China's endless trade surplus is very real and that it is not going to be resolved sensibly any time soon.

China's envoy to the World Trade Organisation blamed the US for letting the dollar depreciate and thus, in his view, running up commodity prices as well as reducing the value of China's dollar-denominated reserves.

The American envoy to the WTO has pointed to China's protections of strategic industries that underlie friction with trading partners. The reality is that it takes at least two to do the dollar depreciation tango. China is playing a tricky game. If it refuses to open up to much more significant imports from the West, it has to choose whether to take a big one-time loss on its dollar reserves by selling them off now or to keep on stashing its trade surpluses in US bonds. The first option would disrupt the US economy and world trade to an extent that would frighten the Chinese leadership. If it happens, it will probably be by accident.

To return to Ben Bernanke's choice, what should he do about monetary policy? The Fed has never been supposed to weigh the dollar exchange rate in its decisions explicitly, though since the dollar's trade value affects inflation it must always be a hidden concern. Yet a rise in interest rates beyond a token amount could both de-stabilise the more shaky banks and tip another tranche of adjustable rate mortgages into default. It certainly looks as if Mr Bernanke is in a bind.

A former senior executive with a home builder told me he is not sure that the decision will be in Ben Bernanke's hands for much longer. He thinks that an inflation scare, maybe mixed up with a dollar scare, will take hold among global bond investors and cause them to demand higher interest rates in return for continued lending to the US. If he is right, that will make managing the world economy a whole lot tougher.