10.01.2008 0

Better Late than Never

  • On: 10/13/2008 12:06:39
  • In: Monetary Policy

  • “[T]he latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations. The Federal Open Market Committee will strongly resist an erosion of longer-term inflation expectations, as an unanchoring of those expectations would be destabilizing for growth as well as for inflation.”Ben Bernanke, Federal Reserve Chairman, June 9th, 2008.

    With those words, Ben Bernanke may be on the path to redemption from his previous weak dollar policies. Though that path may have in truth been a bit misguided, his revelation is better late than never. And to quote the bard, “Thereby hangs a tale.”

    What he did say certainly represents a shift in policy for the nation’s central bank. In his speech at the Federal Reserve Bank of Boston’s 52nd Annual Economic Conference in Chatham, Massachusetts, Mr. Bernanke threw down the gauntlet that the Federal Reserve is going to be watching inflation very closely and as necessary take action to control it.

    And that is certainly welcome news.

    As everyone has noticed, the prices of commodities like food and energy have been soaring over the past few years. And as ALG News has been reporting, Fed policy has had a significant impact upon those prices, with Fed-set low interest rates directly impacting upon higher commodity prices as investors put money into commodities as a hedge against the resulting weak dollar.

    Mr. Bernanke noted the prominent increases in commodity prices,

    “Inflation has remained high, largely reflecting sharp increases in the prices of globally traded commodities. Thus far, the pass-through of high raw materials costs to the prices of most other products and to domestic labor costs has been limited, in part because of softening domestic demand. However, the continuation of this pattern is not guaranteed and future developments in this regard will bear close attention. Moreover, the latest round of increases in energy prices has added to the upside risks to inflation and inflation expectations.”

    In other words, the reason for the high prices, according to Mr. Bernanke, is, well, high prices. To be fair, he really means that the increases of prices of commodities are being passed through to the costs of other goods and services, and this pattern runs the risk of growing.

    This is a chicken-and-the-egg question: Are higher commodity prices causing inflation? Or is inflation causing higher commodity prices?

    How the world’s most important central bank answers that question will have profound implications on how the Fed makes decisions now to curb inflation, and how it will act in the future to prevent today’s troubling circumstances from recurring.

    Mr. Bernanke also stated that “[r]apidly rising prices for globally traded commodities have been the major source of the relatively high rates of inflation we have experienced in recent years…” Which is true. Rapidly escalating prices would certainly show up in the Consumer Price Index, often the measure for inflation.

    So, what has caused the price spikes? As ALG News has reported, part of the equation is demand-pull inflation: Increased demand for commodities without increasing suppy has resulted in an increase in prices.

    And that certainly is part of the problem. Energy demand has indeed been increasing over the past two decades, and yet the U.S. has not made aggressive efforts to increase energy production. And meanwhile the rest of the world is reaching its capacity of production.

    However, demand may be up but it has not doubled in the past year, and yet that’s exactly what the price of oil has nearly done, moving from about $70 per barrel at this time last year to nearly $140 per barrel today. That means that a demand explanation for the price of oil—which is certainly a major factor of long-term growth in prices—is insufficient when it comes to explaining these short-term fluctuations.

    Which means something else has to have been contributing to those price spikes.

    As ALG News has reported, publisher Steve Forbes believes that at least half of the price of oil is because of the weak dollar. And there is a growing consensus that the causes for America’s price problems extend beyond normal supply and demand constraints. Including apparently, Mr. Bernanke.

    ALG News is very pleased to report that Mr. Bernanke has at last acknowledged that there is more to the price of oil than supply and demand. And he even included aspects of monetary policy which may be playing a significant role:

    “Empirical work on inflation, including much of the classic work on Phillips curves, has generally treated changes in commodity prices as an exogenous influence on the inflation process, driven by market-specific factors such as weather conditions or geopolitical developments. By contrast, some analysts emphasize the endogeneity of commodity prices to broad macroeconomic and monetary developments such as expected growth, expected inflation, interest rates, and currency movements [emphasis added].

    “Of course, in reality, commodity prices are influenced by both market-specific and aggregate factors. Market-specific influences are evident in the significant differences in price behavior across individual commodities, which often can be traced to idiosyncratic supply and demand factors. Aggregate influences are suggested by the fact that the prices of several major classes of commodities, including energy, metals, and grains, have all shown broad-based gains in recent years [emphasis added].

    “In particular, it seems clear that commodity prices have been importantly influenced by secular global trends affecting the conditions of demand and supply for raw materials. We have seen rapid growth in the worldwide demand for raw materials, which in turn is largely the result of sustained global growth–particularly resources-intensive growth in emerging market economies.

    “And factors including inadequate investment, long lags in the development of new capacity, and underlying resource constraints have caused the supplies of a number of important commodity classes, including energy and metals, to lag global demand. These problems have been exacerbated to some extent by a systematic underprediction of demand and overprediction of productive capacity for a number of key commodities, notably oil.”

    Mr. Bernanke then called for more analysis of “the range of aggregate and idiosyncratic determinants of commodity prices” to aid in the Fed’s new-found apparent determination to defend the dollar, and in extension, bring down the prices of commodities that are hurting the economy.

    So, there may be a silver lining in the last few months of economic turmoil: The experience has apparently had a profound effect upon the nation’s central bank, which finally appears prepared to strengthen the dollar.

    Better late than never. But better never late. Don’t let it happen again.

    ALG Perspective: Finally there is institutional agreement that the Fed needs to control inflation. President Bush recently called for strengthening the dollar, and he too has apparently seen the tea leaves. With Mr. Bernanke’s statement, market sentiment is that interest rates will begin rising sooner than had been previously predicted. And that is a strong part of the prescription for increasing the value of the dollar, which will add value to the nation’s economy. Here’s a bit of advice: it needs to do it sooner rather than later.

    But it may not be enough. America must reevaluate its monetary policy. Stronger interest rates—and a resultant stronger dollar—could run the risk of making policymakers believe that that was all that needed to be done. Interest rate increases are likely to have near-term implications, but there is an underlying problem and policymakers must consider if it is not an institutional problem.

    The Fed needs to get off its mission of stimulating economic growth—something that can and will take care of itself via the free market if it is allowed to operate—as Congressman Paul Ryan has suggested with his legislation, the Price Stability Act. And, Steve Forbes has also called for moving to a new, modern gold standard. Finally, Larry Kudlow, one of the strongest dollar defenders, has called for coordinating efforts internationally with the G7, as well as Treasury action. Those options must be considered, too, so that the American people suffering from spending ever-increasing dollars on commodities—those staples such as food and energy—may be assured that this will never happen again.

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