Sand Castle Monetary Policy

February 21, 2011

by Mario Rizzo  

Chairman Ben Bernanke says don’t blame the Fed for rapidly increasing commodity prices and probable bubbles forming in many investment markets throughout the world. I am just doing what is necessary for a recovery in the US and that is in the interests of the world. (See “Bernanke Defends US Policies” Wall Street Journal, February 19-20).  

The reality is different. From a short-run point of view there is no reason for Bernanke to care what is going on in other nations. He will be judged “by history” by what happens here in the US. Therefore, he cannot be trusted to take the costs of policy – elsewhere in the world – fully into account. However, since bursting bubbles will affect asset markets here, he may begin to worry later.

And yet our fellow is boxed in. As he creates more money, and keeps interest rates low, in an effort to spur spending, much of the money will chase higher, riskier yields in foreign markets. From a US perspective, damage to foreign markets may just be the price we – oops they – have to pay.   

But is the US successfully shifting the costs of its monetary policy to foreign countries? The prevailing view at the Fed and elsewhere seems to be as long as “inflation” is under control then the appropriate policy is further stimulus through quantitative easing. But wait a minute. The last two recessions – including the so-called Great Recession – were not preceded by bouts of inflation. Obviously, then, bad things can happen without general inflation.  

Bernanke realizes that overall measured inflation is not increasing (as much as he thinks bad, that is) because (1) the prices of services are relatively stable and (2) food and other commodity-dependent prices are excluded, by definition, from core inflation. 

On the first point, I should think that service prices – closer in general to the consumer stage – would not be as affected by low interest rates as those sectors farther from consumption. Certainly, at the early stages of massive credit expansion with low interest rates this is the case. On the second point, there is a sensible case to be made for excluding food and fuel if they are simply being “normally” volatile – that is, experiencing ups and downs due to weather or other temporary factors.  (Let us put aside for the moment commodity price appreciation due to political unrest in the Middle East. The rise in commodity prices predates this.)  

But we have other plausible explanations. Commodity prices are a frequent indicator of inflationary fears. They are also, because of their volatility, a good vehicle for speculative demands – money in search of higher returns. Furthermore, to the extent that other economies are over-heating, in part due to US policy, their demands for commodities of all kinds will increase. These demands are not sustainable – which is the point.  

Closer to home, the stock market (S&P) has now experienced the fastest rise ever in the past two years, just about doubling. Is that because the Fed has made everything all better now and we are almost back we started from? Or are we witnessing the curious combination of firms being cautious about real investment and financial investors seeking yield? Money created out of thin air needs to find a home. 

 (Of course, the averages are helped a lot by bank stocks doing well as a result of the infusion of TARP money. But that has covered up the real negative value of the banking sector and built expectations of further rescues when behavior is not sustainable.)  

A non-sustainable stock market rise based on expectations of bailouts if bubbles burst is a fine recipe for future difficulties. 

I do not pretend to have definitive answers but there is certain complacency emanating from Bernanke that is not warranted either by his personal record at the Fed or by the facts. I know people will say that he must project self-confidence for the sake of the markets. I am not of big fan of purely atmospheric confidence, that is, of thinly-based confidence.  

I fear we are living in a precarious world with the Fed building sand castles. But at least Bernanke has his self-confidence.

7 Responses to “Sand Castle Monetary Policy”


  1. This is a bit tangential, but you bring up the topic of consumer good prices. I think, generally, you’re correct. The question is: what type of spending do low interest rates influence? A recent topic of discussion, related to this one, is the effect of low interest rates on consumer spending through credit. But, most credit card companies are now charging insanely high rates, right? I know some are charging 24-30% if you miss a payment, or they offer “no interest” for six months and then spike the rate.

    In any case, that’s just a side thought, with hardly any implication. I mean, does consumer credit spending outweigh investment through credit? I don’t think so.

    On a related note, I don’t think the low interest rates have really been causing a higher degree of investment in goods farther away from the final stages. In fact, investment spending has either been stagnating or it has been falling (see Robert Higgs’s recent post on The Beacon).

    What we’re seeing is a strict rise in the price of commodities on the market. Krugman argues that this spike in prices hasn’t led to increases in the price of their products, because these costs are “built in” according to him (the cost of the commodity is a low percentage of what the product actually tends to sell for), but I recall reading a recent article which suggested the exact opposite (from a producer of one of these products; I can’t remember exactly).

    What I’ve always wondered is how exactly new money created by the Federal Reserve goes into the commodities market. Who borrows from where? Do “normal” (i.e. low income) investors borrow to invest?


  2. During the 2008 food crisis complex econometric regressions pointed the blame on bio-fuel policies for 74% of the price increases (if I recall correctly). What evidence do we have that this time around it is primarily, or substantially, fueled by inflation?


  3. Bernanke is in denial. Commodities (and most traded goods) are priced in dollars. The Fed produces base money. More dollars, higher commodity prices.

    Of course, it is true that central banks in other countries could offset the Fed’s easy money policy. They could raise interest rates, see their currencies appreciate, and through their economies into recession. In truth, Bernanke is just repeating Treasury Secretary Connally’s famous quip that the dollar is our currency and your problem.

    Consumer price inflation is suppressed here because 2.5 billion Chinese and Indians produce cheap goods and take dollars in return. But there is plenty of US-exported inflation in Asia.

    As to asset bubbles: Asian real estate; gold and silver (and commodities generally); and equities. My former colleague, Bob Barnett, has suggested adding Midwest farmland.


  4. A nice post!

    @ Jerry:

    I generally agree, but I am not sure about the following.

    “Of course, it is true that central banks in other countries could offset the Fed’s easy money policy. They could raise interest rates, see their currencies appreciate, and through their economies into recession.”

    I think emerging markets do this. But this just widened the interest rate spread between the US and other countries and brought about additional speculative dollar investment into e.g. stock markets, especially since the exchange rate appreciates (which increases returns after converting back into dollar).

    From this perspective, I do not see how small “periphery” economies could lean against the dollar flood.


  5. @Andreas, point taken. That only makes Bernanke’s position more indefensible.

  6. Scott Says:

    The cycle of inflation is one where demand for labor pushes up wages, and thereby pushes up prices for the good/services produced by that labor. So pay attention to wages. At 9-10% unemployment there is no upward pressure on wages. QE2 will run its course by late summer or early fall, we will not have anything like normal (5%) unemployment by then.

    In short, this piece seems motivated by something other than basic economics.


  7. In today’s Wall Street Journal, George Melloan takes on Bernnake’s defense of his policies.

    http://online.wsj.com/article/SB10001424052748704657704576150202567815380.html?mod=WSJ_Opinion_LEFTTopOpinion


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