Wednesday, November 14, 2007

Does The Federal Reserve Cause Inflation


I received an email that cited several sources [for example]regarding an exchange between Dr. Ron Paul and Ben Bernanke, Chairman of the Federal Reserve. The question on the table was whether the Federal Reserve caused inflation. I responded:

"The Fed doesn't cause inflation or deflation, but the Fed certainly mucks up the economy from time to time; e.g., lowering Fed rates to 1% which got everyone on the borrowing bandwagon and many into ARMs that were unrealistic... and then rapidly increasing Fed rates to 5.0%+ which, on a relative basis, put the costs of borrowing much higher than people could afford given their commitments at lower rates... all in the name of protecting the nation against inflation when it simply made a mess out of the financial and housing markets."
I went on to say:
"But to the point of inflation:
  • underlying problem is price of oil/energy due to congress [primarily Democrats] restricting U.S. exploration of oil and oil companies failing to build refineries while at the same time not addressing the need for more electric power generated by nuclear power or clean coal... not the Fed changing interest rates
  • underlying problem is U.S. business dealing with unions and foreign competitors at the same time which has moved production/sourcing overseas and created massive negative imbalances in the current account leading to a weaker dollar... not the Fed actions... while reducing the better paying jobs in the lower-middle class
  • underlying problem is an expensive war that has created significant Federal debt/borrowing lowering the value of the dollar... not the Fed.
The Fed has created problems... just not the ones that RP is chasing."
Does raising interest rates exacerbate inflation caused by other factors? To a certain extent, yes, by adding to the cost of goods and services. Does raising interest rates fight inflation? Beyond a certain level, raising interest rates creates huge economic problems by crushing the marketplace under untenable costs which then precipitates a "fire sale" situation.
I guess that could be called "fighting inflation", but the reality is that it is simply creating major economic losses for many businesses and individuals. It is the equivalent of treating skin cancer with plutonium dust.
Furthermore, with the emergence of China as a major driver of the world economy, the ability of the Fed is lessening to affect worldwide inflation by dampening economic activity around the world.
Consequently, when the Fed raises its lending rates, U.S. businesses and individuals increasingly bear the brunt of that action while the rest of the world merrily goes on its own way.
Perhaps it is time for a change in the mission and methods of the Federal Reserve.


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Tracking Interest Rates

Tracking Interest Rates


SEARCH BLOG: FEDERAL RESERVE for full versions... or use the Blog Archive pulldown menu.

February 3, 2006
Go back to 1999-2000 and see what the Fed did. They are following the same pattern for 2005-06. If it ain't broke, the Fed will fix it... and good!
August 29, 2006 The Federal Reserve always acts on old information... and is the only cause of U.S. recessions.
December 5, 2006 Last spring I wrote about what I saw to be a sharp downturn in the economy in the "rustbelt" states, particularly Michigan.
March 28, 2007
The Federal Reserve sees no need to cut interest rates in the light of adverse recent economic data, Ben Bernanke said on Wednesday.
The Fed chairman said ”to date, the incoming data have supported the view that the current stance of policy is likely to foster sustainable economic growth and a gradual ebbing in core inflation”.

July 21, 2007 My guess is that if there is an interest rate change, a cut is more likely than an increase. The key variables to be watching at this point are real estate prices and the inventory of unsold homes.
August 11, 2007 I suspect that within 6 months the Federal Reserve will be forced to lower interest rates before housing becomes a black hole.
September 11, 2007 It only means that the overall process has flaws guaranteeing it will be slow in responding to changes in the economy... and tend to over-react as a result.
September 18, 2007 I think a 4% rate is really what is needed to turn the economy back on the right course. The rate may not get there, but more cuts will be needed with employment rates down and foreclosure rates up.
October 25, 2007 How long will it be before I will be able to write: "The Federal Reserve lowered its lending rate to 4% in response to the collapse of the U.S. housing market and massive numbers of foreclosures that threaten the banking and mortgage sectors."
"Should the elevated turbulence persist, it would increase the possibility of further tightening in financial conditions for households and businesses," he said.

"Uncertainties about the economic outlook are unusually high right now," he said. "These uncertainties require flexible and pragmatic policymaking -- nimble is the adjective I used a few weeks ago."

December 11, 2007 Somehow the Fed misses the obvious.
[Image from:]
December 13, 2007 [from The Christian Science Monitor]
"The odds of a recession are now above 50 percent," says Mark Zandi, chief economist at Moody's "We are right on the edge of a recession in part because of the Fed's reluctance to reduce interest rates more aggressively." [see my comments of September 11]
January 7, 2008 The real problem now is that consumers can't rescue the economy and manufacturing, which is already weakening, will continue to weaken. We've gutted the forces that could avoid a downturn. The question is not whether there will be a recession, but can it be dampened sufficiently so that it is very short.
January 11, 2008 This is death by a thousand cuts.
January 13, 2008 [N.Y. Times]
“The question is not whether we will have a recession, but how deep and prolonged it will be,” said David Rosenberg, the chief North American economist at Merrill Lynch. “Even if the Fed’s moves are going to work, it will not show up until the later part of 2008 or 2009.
January 17, 2008 A few days ago, Anna Schwartz, nonagenarian economist, implicated the Federal Reserve as the cause of the present lending crisis [from the Telegraph - UK]:
The high priestess of US monetarism - a revered figure at the Fed - says the central bank is itself the chief cause of the credit bubble, and now seems stunned as the consequences of its own actions engulf the financial system. "The new group at the Fed is not equal to the problem that faces it," she says, daring to utter a thought that fellow critics mostly utter sotto voce.
January 22, 2008 The cut has become infected and a limb is in danger. Ben Bernanke is panicking and the Fed has its emergency triage team cutting rates... this time by 3/4%. ...

What should the Federal Reserve do now? Step back... and don't be so anxious to raise rates at the first sign of economic improvement.
Individuals and businesses need stability in their financial cost structures so that they can plan effectively and keep their ships afloat. Wildly fluctuating rates... regardless of what the absolute levels are... create problems. Either too much spending or too much fear. It's just not that difficult to comprehend. Why has it been so difficult for the Fed?

About Me

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Michigan, United States
Air Force (SAC) captain 1968-72. Retired after 35 years of business and logistical planning, including running a small business. Two sons with advanced degrees; one with a business and pre-law degree. Beautiful wife who has put up with me for 4 decades. Education: B.A. (Sociology major; minors in philosopy, English literature, and German) M.S. Operations Management (like a mixture of an MBA with logistical planning)