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Stop The Fed Before It's Too Late

By Hossein Askari and Noureddine Krichene

31/05/08 "
Asia Times" -- Since the Fed in August 2007 aggressively resumed the inflationary policy it had followed during 2001-2006, oil prices have been rising at an accelerating pace, from US$65 to $135 per barrel, food prices have increased at an unprecedented rate causing riots around the globe, and the dollar has been sinking.

Each interest rate cut has been immediately followed by an inflationary spike in oil and food prices and a falling dollar; and in turn accompanied by a rapid fall in real incomes of the working classes and pensioners. It would appear that the Fed has beentrying to repair the dire consequences of its overly expansionary policy of 2001-2006 by ominously and erroneously pursuing a re-inflationary policy aimed at jerking up falling housing prices and rescuing failing banks.

But the Fed's present course could lead to serious social and economic consequences. While the Fed has failed to reverse housing prices, which continue to be depressed, it has pushed the US economy into a likely recession, accelerated inflation, and could disrupt vital energy and food markets, risking malnutrition and social stability in many countries.

Oil and food producers are increasingly reluctant to increase supply. The recent lukewarm response of Saudi Arabia to US pressure for higher oil output is evidence of commodity suppliers' reluctance to increase supplies in the context of accelerating inflation. As inflationary expectations are met, producers have become certain they can generate more revenues by contracting supply.

The supply-side response cannot be addressed in the context of strong inflationary expectations. While the US Congress, policymakers, and the public are in disarray looking for explanations for the present oil and food crisis, blaming voracious speculators, irresponsive supplies, oil companies, biomass fuel, and restrictions on drilling, no official explanation has focused on the monetary cause of this inflationary spiral that has started. Meanwhile, the Fed has exploited this state of ignorance to pursue its independent role in destabilizing the world economy.

Accelerating oil and food prices inflation is largely a monetary phenomenon and cannot be attributed to hedging, speculation and oil company behavior. Elementary monetary theory states that excess liquidity injected into the economy creates an excess demand for commodities and leads to a bidding up of prices.

The central bank accommodates new increases in prices by supplying more liquidity. The process of rising prices and accommodation continues until the central bank decides to reduce money supply or until there is an economic collapse.

Hedgers and speculators do not dictate policies and cannot influence longer-term trends. Hedgers hedge against consequences of bad policies and speculators take advantage of the repercussions of unsustainable economic policies.

As predictable exchange-rate depreciation and oil and food price increases materialize, inflationary expectations become fulfilled, leading in turn to an intensification of speculation and an acceleration of inflation. In other words, an acceleration of price inflation is evidence for inflationary expectations. Maintaining the current policy stance would only reinforce hedging, speculation and inflationary dynamics.

The recent excessive easing of monetary policy has made oil and food price inflation unmanageable. A comparison of interest rates during the stagflation of the 1970s with prevailing interest rates is instructive. During 1979-1982, the federal funds rate peaked at 19% and the prime lending rate to 25%. This has to be compared with current federal funds rate at 2% and prime lending rate at 5%.

Clearly, there is no hope to contain surging oil and food price pressures in the context of such low nominal and largely negative real interest rates. Instead of swift and decisive action to force oil and food prices down by reducing money supply, as would have been strongly recommended by Keynes, Friedman and others, the Fed is perpetuating a state of agony, imposing heavy taxation on working classes and pensioners, stifling economic growth, and destabilizing many economic sectors, not just in the US but around the globe.

The Fed has been trying to control interest rates. Evidently, this type of price control is against the mandate of any central bank, which is primarily entrusted with preserving the value of currency and integrity of the financial system. In the pursuit of its interest rate policy, the Fed has lost control of money aggregates and the supervision of financial institutions.

During an earlier era of liquidity expansion and monetary policy divergence across countries, central banks found it difficult to defend the Bretton-Woods system of fixed exchange rates and had to resort to flexible exchange rates. Today, they will find the same difficulty if they continue to peg interest rates.

The interest rate rule has been repudiated by eminent monetarists as inapplicable to fixed and stable exchange rates and as damaging to fiat money. Monetary orthodoxy requires that a central bank manage liquidity and not interest rates. By forcing interest rates to very low levels and real interest rates to a negative range, the Fed has created a wedge between natural and market real interest rates, leading to reduced savings and huge pressure on oil and food prices as well as to increasingly runaway inflation.

Because of the independent voting power of its members, the Fed has been unable to garner consensus vis-a-vis pressing monetary issues, including the present crisis. Reforms of the Fed decision-making process have long been called for. Strong support by Fed members of the present money stance can be too costly for the US and the world economy.

In view of the urgency of the situation, it will may be necessary for the US executive branch and Congress to design a stabilization strategy, encompassing fiscal and monetary policies in order to contain the deteriorating economic and financial situation. The Reagan stabilization program worked nicely and could certainly be emulated in the present crisis. Beside sharp monetary contraction, that Reagan plan included selected fiscal policies aimed at propelling private investment and economic growth. If the US government and Congress decide to remain on the sidelines in the name of Fed independence, the inflation dragon will stifle the economy, cut real incomes and standards of living, and cause widespread unemployment and social disenchantment.

So what has the Fed accomplished since August, 2007? The Fed has been largely responsible for the free fall of the dollar and for the explosion of oil and food prices, as oil and food supplies remained stable and were not affected by supply shocks. Oil supplies in fact increased by 2.1 million barrels per day (mbd) from 85.2 mbd in August 2007 to 87.3 mbd in March 2008 (IEA Oil Report). In turn, the Fed has depressed the outlook for real economic activity.

Is this a track record to be applauded? Are we to succumb to the Fed's disastrous policy? Are the policymakers to remain totally passive while the whole country and world economy are in an economic crisis? The longer an effective stabilization plan is delayed, the higher the risk of a severe economic downturn.

The same US president that pleaded with Saudis to increase oil supplies should now plead with the Fed to change its monetary course. A call from President George W Bush and Congress could help rein monetary policy and in turn stabilize oil and food markets as we await an effective stabilization plan.

Hossein Askari is professor of international business and international affairs at George Washington University. Noureddine Krichene is an economist at the International Monetary Fund and a former advisor, Islamic Development Bank, Jeddah.

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