Let Them Eat Cake

Fed Chairman Ben Bernanke’s flippancy in dealing with serious questions is becoming more and more disturbing.  He responded to legitimate questions about the credibility of the Fed’s promises to cut back on its expansive policies if inflation appears to be picking up by saying that he could raise interest rates in five minutes, if need be.  Procedurally, this is true, but substantively, this is a non-answer because it completely ignores the credibility issue: would the Fed have the political will to implement controversial rate hikes when the economy is still less than robust (as today’s employment report makes plain)?

But yesterday his flippancy soared to new levels (sort of like the monetary base and the Fed balance sheet).  In response to questions about the effects of QE2 on inflation around the world–notably food price inflation that has helped spark unrest in Egypt and elsewhere–Bernanke was dismissive:

Answering questions after a speech at the National Press Club in Washington, Mr Bernanke said that rising food prices in the emerging world reflected the growing wealth of their populations and, in some countries, a failure to tackle inflation.

“They can, for example, use monetary policy of their own. They can adjust their exchange rates, which is something that they’ve been reluctant to do in some cases,” Mr Bernanke said.

Here’s more:

“I think it’s entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries,” he said in answering a question from the audience. “It’s really up to emerging markets to find appropriate tools to balance their own growth.”

Here’s an analogy.  Neighbor Ben is lighting bonfires in his yard in a windstorm.  He responds to your complaints that the flames and sparks from his fire have torched your bushes and threaten to set your house alight by saying: “You have all the tools you need to address the problem.  You could buy a fire extinguisher.  You could soak down the roof of your house.  You could move.”

Food price spikes in particular have been fueled largely by supply shortages, but the boom in commodity prices is so widespread–from copper (now over $10K/tonne) to oil ($100+ for Brent), to cotton (leading to an extraordinary exchange intervention) that it is difficult to deny that expansive US monetary policy has something to do with it.  I say again.  Bernanke has justified QE2 by citing deflationary fears: when–ever–has a deflationary cycle been accompanied by spiking commodity prices?  Usually commodity prices plunge the most.  At least, this should be sparking some cognitive dissonance, a recognition that this isn’t your grandfather’s Depression–even if said Depression was the focus of your academic research.  (Generals fighting the last war are very dangerous–to their own side.)

Bernanke is also rhetorically slippery.  He says that “it is entirely unfair to attribute excess demand pressures in emerging markets to U.S. monetary policy, because emerging markets have all the tools they need to address excess demand in those countries.”  That is a non sequitur.  It is entirely possible–and indeed extremely plausible–that US monetary policy has a lot–a lot–to do with excess demand pressures in emerging markets.  That’s the underlying shock: at least it’s one, big, undeniable shock.  The channels of transmission are plainly evident.  Whether countries have the policy tools to respond to that excess demand is an entirely different issue; whether they use them is another.  The source of excess demand pressures and the response to it are completely distinct.  Your failure to buy a fire extinguisher to defend yourself against Neighbor Ben’s pyromania does not mean that the pyromania is an illusion.  It is illogical to claim that because countries have not responded to X the way Bernanke would prefer, X therefore does not exist.  And QE2 is the big X factor.

Bernanke may have let the cat out of the bag and revealed an important–but not publicly emphasized–rationale for QE2 in his remark that countries “can adjust their exchange rates.”  Namely, this suggests that QE2 is intended primarily to reduce the value of the dollar.  To put pressure on countries–most notably China–to let their currencies rise relative to the dollar.  By a lot.  This is, in essence, a big game of chicken between Bernanke and policy makers around the globe–and most importantly, in Beijing.

Inflation is painful.  Currency appreciation brings its own kinds of pain, in the short run, anyways.   Countries are understandably–predictably–reluctant to let it happen.  QE2 has put them between a rock and a hard place.  And the choice is particularly discomfiting in China.  The Chinese have their own rather deep concerns about the robustness of the economy and the potential for social unrest.  Moreover, historical grievances and a current sense of ascendency make them particularly reluctant to knuckle under to the US.  So the game of chicken is likely to continue, and end with a crash rather than a saving swerve by the Chinese.

But even if the game is between the US (and the Fed in particular) and China, the repercussions are global in scope.  The collateral damage is already large, and threatens to spin out of control.  We are in a Year of Living Dangerously, and despite Bernanke’s flat (but illogical) denials, a major source of that danger is US monetary policy.

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About Craig Pirrong 238 Articles

Affiliation: University of Houston

Dr Pirrong is Professor of Finance, and Energy Markets Director for the Global Energy Management Institute at the Bauer College of Business of the University of Houston. He was previously Watson Family Professor of Commodity and Financial Risk Management at Oklahoma State University, and a faculty member at the University of Michigan, the University of Chicago, and Washington University.

Professor Pirrong's research focuses on the organization of financial exchanges, derivatives clearing, competition between exchanges, commodity markets, derivatives market manipulation, the relation between market fundamentals and commodity price dynamics, and the implications of this relation for the pricing of commodity derivatives. He has published 30 articles in professional publications, is the author of three books, and has consulted widely, primarily on commodity and market manipulation-related issues.

He holds a Ph.D. in business economics from the University of Chicago.

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