Inflationary or Disinflationary?

Rising oil prices, falling US dollar, skyrocketing commodity prices all point to more inflation for the US economy, or do they? What about the effects of a slowing economy and falling house prices? Just a couple of years ago, the world was toasting to the Goldilocks US economy, growing without inflation, not too hot and not too cold. Now, it is a case of one foot hot and one foot cold, a real dilemma for central bankers.

Asymmetric Monetary Responses

The story went like this. The benign global economy transformed by the supply side revolution of China and other developing economies had brought great benefits in terms of output expansion. Interest rate stayed as low and for as long as they had been for a long time. Even though general consumer price inflation was low, asset prices like housing started to bubble over worldwide. The Greenspan doctrine was that it was too dangerous for central bankers to try to target asset prices, so they were left completely unchecked as the rest of the economy coasted along.

Suddenly there was the realisation that asset prices could no longer be sustained, and the bust came at a time when the world was beginning to face a supply side shortage. Commodity and consumer inflation started to rise, but assets began to deflate. It is easy to treat a patient with fever, give the medicine to bring the temperature down. It is equally easy to treat a patient with hypothermia, just warm him up. But what do you do to a patient with fever and hypothermia at different parts of the body at the same time? This is exactly Tinbergen's dilemma, how do you hit two targets with one arrow? You pray!

Cutting interest rates to support asset prices would risk sending inflation even higher. Not cutting would risk making the post-bubble financial turmoil worse. By December, we will know if Fed is indeed serious about the inflation fighting or is it really an emperor with no clothes. My personal assessment is that Fed will have to make more cuts, even if it strenuously denies it at the moment.

It is also here that the Greenspan doctrine ties itself to intellectual knots. To leave asset price rises unchecked, while opening the door for interest rate cuts and bailouts when asset prices fall is exactly the kind of policy asymmetry that leads the market into making one-sided bets. Revisionist talk this is not, many economists have long been arguing that monetary policies were too loose too long.

Risks for Rest of the World

As difficult a job as the one Bernanke is doing, we have to remember this. When Fed weighs in on its monetary policy stance, it cares only of the risks facing the US economy. Given how dependent the rest of the world is on the US, this is an extraordinary situation. By cutting interest rates and driving US dollar ever lower, it places severe strains on economies elsewhere. Those countries pegged to US dollar will face either higher inflation, or will have to abandon the peg altogether, both of which will lead to more financial turmoil.

The Euro and Pound are both soaring relative to the US dollar at a time their own economies are too entering the down cycle. Just yesterday, French President Sarkozy fired off a warning shot that US could not expect to devalue its way out of trouble of its own making, and implicitly threatened competitive devaluation. While he in reality did not have control over the ECB, he very much captured the mood over in Europe. The sense was that the European economies were at the short end of it all, being punished for someone elses' sins.

What we have seen in the past three months is probably only the beginning act of a period of economic turbulence.