'Cowboy Keynesianism' that the Fed may soon regret
Published: September 28 2007 03:00 | Last updated: September 28 2007 03:00
>From Prof Jeff Frank.
Sir, Martin Wolf makes a good point about how "the Fed must weigh inflation against the risk of recession" (September 26).
The test may come very soon. It is likely that the Fed cut rates by 50 basis points precisely because the window for cutting is short. Prices fell sharply between August and September last year. Next month's change in the base for year-on-year CPI inflation to September leads to some ugly arithmetic. Even if prices didn't rise at all in September 2007, headline CPI will rise from 1.97 per cent to 2.47 per cent. But we know that energy prices rose sharply in September, so the headline will rise to nearly 3 per cent. The baseline shift effect is even worse for October! Further, the moderation in core inflation may be due to lagged effects from the fall in energy input costs in the second half of 2006. If so, this is likely to be reversed as well. Inflation may well be over 4 per cent by the end of the year.
The big US inflation of the 1970s was set in motion in 1968. In June 1968, headline CPI crossed over 4 per cent. In September 1968, perhaps under political pressure, the Fed lowered the Fed funds rate by 25 basis points to 5.75 per cent. It reversed this by December and then started raising rates sharply, peaking the next year over 9 per cent. In hindsight, that was viewed as an irresponsibly accommodative Fed. In comparison, the 50bps cut by the Bernanke Fed is "cowboy Keynesianism".
US public and private debt is hugely out of equilibrium. There are four ways equilibrium can be restored. US consumers and the US government can cut their expenditure to repay the debt. They can default on some of the debt. They can renegotiate some of the debt. Or the Fed can inflate away the real value of the debt.
Mr Wolf recognises that inflation is the easiest course. Realistically, it may be the only option open to a country that finds it difficult to live within its means. The US will have traded toxic debt to China for lead-painted toys.
Jeff Frank,
Professor of Economics, Royal Holloway, University of London, Egham, Surrey TW20 0EX, UK