Monday, October 1, 2012

Economist Who Early On Warned about Eurozone Now Warns of Inflationary Consqeuences of Fed Policies

My favorite Keynesian economist, Martin Feldstein, is out with a warning about the price inflationary consequences of current Federal Reserve monetary policy.

Note: This man understands monetary policy.

In an article, "EMU and International Conflict," published in the November 1997 issue of Foreign Affairs, Feldstein nailed the many destabilising factors surrounding the EU construct. Here's part of a summary by Joel Meeker of Feldstein's paper (The paper itself is not online):
Feldstein believes that the transition to the Euro may well bring about two unexpected results: an increasingly contentious and perhaps only short-lived union among European participants, and conflict between Europe and other countries, including the United States. He presents the following scenario: Existing disagreements on goals and methods of monetary policy among European Monetary Union (EMU) participants would be aggravated when normal business cycles raise unemployment in any given country...This would cause a rise in inter-European distrust, which would be compounded by unrealized expectations about power sharing, as well as both domestic and international policies...

As to the smaller EMU countries, Feldstein maintains they will become frustrated by the increasing dominance of the heavyweights in deciding not only foreign but also domestic policy for the European Union.
In Friday's FT, he took on Bernanke's monetary policy (my bold):
The Federal Reserve has now embarked on a very dangerous strategy, buying $40bn of mortgage-backed securities each month for an indefinite number of years. That could lead to high inflation, to destabilising asset bubbles... 
The Federal Open Market Committee has announced that it will continue those purchases for as long as “the labour market does not improve substantially” and will maintain “a highly accommodative stance of monetary policy ... for a considerable time after the economic recovery strengthens”. It specifically noted that its highly accommodative stance would continue at least until mid-2015, implying nearly $1.5tn of increased bank liquidity. 
Although economic weakness now prevents inflationary price increases, these conditions will not last forever. At some point, demand will increase and companies will recover the ability to raise prices. Such price inflation has historically been associated with tight labour markets and rising wages. But this time the unprecedented high level of long-term unemployment could cause the unemployment rate to remain high even when product markets tighten. 
The Fed has locked itself into a policy of monetary ease for as long as the unemployment rate remains high. Although the FOMC said that its policy would be conducted “in the context of price stability”, it is clear that its real focus will be on unemployment...
And even when the Fed wants to start raising interest rates to reduce inflationary pressures, Congress is likely to object if the unemployment rate is still high. Although the Fed is technically independent of the White House, it is legally accountable to the Congress. The recent Dodd-Frank legislation showed how Congress can limit the Fed’s powers. Faced with the alternative of antagonising the Congress, the Fed might delay in raising interest rates to control incipient inflation. The result could be significant increases in inflation and in inflation expectations.
I view the unemployment situation a bit differently than Feldstein. I think it will fall somewhat, though regulations make it much more risky for employers to take on new hires.

But Feldstein's most important point is similar to a point made by Fed President Charles Plosser, that the Fed will be slow too raise rates in the face of climbing price inflation. They will raise rates some but not enough.

Plosser put it this way:
 I have been a student of monetary theory and policy for over 30 years. One constant is that central banks tend to find it easier to lower interest rates than to raise them. Moreover, identifying turning points is difficult even in the best of times, so timing the change in the direction of policy is always a challenge. But this time, exit will be even more complicated and risky.
Plosser's looking at it strictly from a technical perspective that the Fed is slow to raise rates enough to slow price inflation. Feldstein  is looking at the political pressure that will exist to not raise rates. They are both correct. All elements are in place for the Fed to be very slow to raise rates, which means accelerating price inflation and soaring asset prices are very likely down the road.

1 comment:

  1. The collapse of Keynesian economics can be traced to a single error. GDP is seen as the outstanding measure of economic strength and well- being, which it is not. GDP measures utilization; and it's no secret that consumption can be made to rise through all sorts of unsound and short-sighted rehearsal. So that while expansionary fiscal policy can raise the GDP, it does not add to economic health.