Mar 13 2008

Will the Fed’s easy money policy fuel global inflation?

Inflation Reality Check(The Korea Times)

Harvard Economist Kenneth Rogoff points out that inflation is a major problem in many of the world’s largest economies today:

Inflation in Russia, Vietnam, Argentina, and Venezuela is solidly in double digits, to name just a few possibilities.

Indeed, except for deflation-ridden Japan, central bankers could meet just about anywhere and see high and rising inflation. Chinese authorities are so worried by their country’s 7 percent inflation they are copying India and imposing price controls on food.

Even the United States had inflation at 4 percent last year, though the Federal Reserve is somehow convinced that most people won’t notice.

Usually, inflation can be combatted with restrictive monetary policy, or the selling of bonds on the open market, which reduces the money supply, raises interest rates and slows down consumption and investment, and thus the pressure on prices in the economy. Today, however, the US Fed is in the process of expanding money supply and lowering interest rates, in an attempt to avoid a recession at home.

In a world of isolated economies, the US monetary policy would only affect the US economy; however, today the US economy finds itself intertwined in complex ways with other economies of the world.

America’s inflation would be contained but for the fact that so many countries, from the Middle East to Asia, effectively tie their currencies to the dollar. Others, such as Russia and Argentina, do not literally peg to the dollar but nevertheless try to smooth movements.

As a result, whenever the Fed cuts interest rates, it puts pressure on the whole “dollar bloc” to follow suit, lest their currencies appreciate as investors seek higher yields.

Looser U.S. monetary policy has thus set the tempo for inflation in a significant chunk ? perhaps as much as 60 percent ? of the global economy.

The reason other countries must mimic US monetary policies has to do with exchange rates, which many countries try to peg to varying degrees to the value of the dollar. One of the determinants of exchange rates is relative interest rates between countries. If the US lowers interest rates, and a country like Argentina keep rates high, global investors looking for a return on their savings will take their money out of US savings accounts and deposit it in Argentinian savings accounts, where they can earn a greater interest rate. In order to save in Argentina, investors need to convert their dollars to Argentinian pesos, driving up demand for pesos and the dollar/peso exchange rate. A stronger peso could have negative impacts on demand for Argentina’s exports as they become more expensive to foreign consumers. In order to avoid appreciation of its currency and declining demand for its exports, Argentina is thus forced to lower its own interest rates as the Fed cuts those in the US.

When you consider that much of the world adjusts its currency in relation to the dollar, you can see how an easy money policy in the US could lead to falling interest rates worldwide, triggering all sorts of new consumption and investment, driving price levels ever higher.

There is hope for curing the inflation problem. Relief may come at a price for Americans, however:

If the U.S. tips from mild recession into deep recession, the global deflationary implications will cancel out some of the inflationary pressures the world is facing.

Global commodity prices will collapse, and prices for many goods and services will stop rising so quickly as unemployment and excess capacity grow.

Of course, a U.S. recession will also bring further Fed interest-rate cuts, which will exacerbate problems later. But inflation pressures will be even worse if the U.S. recession remains mild and global growth remains solid.

Once again the Fed’s challenge of balancing unemployment, inflation, growth and recession is made clear. The choice of several major world economies to affix their currencies’ values to that of the dollar makes the challenge ever more dire for Mr. Bernanke.

Discussion Questions:

  1. If a US interest rate cut is not matched by countries that tie their currency to the dollar, what would happen to the value of those countries’ currencies?
  2. Why are lower world interest rates inflationary?
  3. What will happen to the value of the Euro if the ECB does not start cutting interest rates soon?
  4. Why might a US recession counter the inflationary pressure caused by rising food and energy prices and loose monetary policy in the US and other nations?

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About the author:  Jason Welker teaches International Baccalaureate and Advanced Placement Economics at Zurich International School in Switzerland. In addition to publishing various online resources for economics students and teachers, Jason developed the online version of the Economics course for the IB and is has authored two Economics textbooks: Pearson Baccalaureate’s Economics for the IB Diploma and REA’s AP Macroeconomics Crash Course. Jason is a native of the Pacific Northwest of the United States, and is a passionate adventurer, who considers himself a skier / mountain biker who teaches Economics in his free time. He and his wife keep a ski chalet in the mountains of Northern Idaho, which now that they live in the Swiss Alps gets far too little use. Read more posts by this author

128 responses so far

128 Responses to “Will the Fed’s easy money policy fuel global inflation?”

  1. cbowieon 30 Apr 2014 at 1:49 am

    1. All other things being equal, these other countries’ currencies should appreciate, causing a rise in imports and lowering of exports.
    2. Lower interest rates discourage saving and encourage consumption. By increasing consumption and demand, lower interest rates might trigger inflation.
    3. The euro will appreciate, as investors will be drawn to the comparatively higher interest rates.
    4. A recession will lower consumption and increase saving. As the US is massive in terms of imports and exports, this decrease in consumption should have a reasonable global effect, countering inflation in other countries.

  2. Koon Con 07 May 2014 at 10:23 am

    1) Those countries' currencies would appreciate due to their higher interest, which will attract foreign investors thus will increase demand for that country's currency.

    2) Lower interest rates allows firms and people to get loans, which will increase the spending thus increases AD, causing inflation.

    3)It will encourage people to exchange their money into Euro, which could cause inflation.

    4) The US will end up in a recession, because the high price of goods will leade to decrease in demand.

  3. cbowieon 07 May 2014 at 11:49 am

    well though out responses, and some new viewpoints i had not considered. good job!

  4. Matilda Unwinon 28 May 2014 at 1:04 pm

    1. If an interest rate cut in America was not matched by countries that tie their currency to the American dollar, what would happen to the value of those countries’ currencies?

    Those currencies would appreciate due to the fact that there would be less demand for the American dollar due to the lower interest rates and more demand for the other tied currencies.

    2. Why are lower world interest rates inflationary?

    Lower world interest rates encourage consumers to purchase more goods and services, hence increasing inflation.

    3. What will happen to the value of the euro if the European Central Bank does not start cutting interest rates soon?

    If the ECB does not start cutting interest rates soon, the euro will appreciate, just as it is already now without interest rate cuts. Whilst there are benefits of this, there are also a number of consequences, including reduced exports due to a decrease in international demand from the appreciation.

    4. Why might an American recession counter the inflationary pressure caused by rising food and energy prices and loose monetary policy in America and other nations?

    A recession in America would lead to a decrease in consumption and an increase in saving, which would hence reduce inflation. As America is a very dominant country on the world market, this recession would have effects on many other countries as well.

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