Inflation, stagflation and deflation

Inflation, stagflation and deflation

 

THE US Federal Reserve meets for the second time this year on March 18. The signals over the past few months show that topping its agenda would be the state of the economy, the turmoil in financial markets and then inflation, in that order; the US central bank has made it clear that in order to stimulate growth and boost the stock market, it is willing to tolerate a sliding dollar and increased inflation. As a result, most commentators expect another 50 basis-point cut in the benchmark Fed funds rate at this month’s meeting, with some predicting a 100 basis-point reduction. Would a big rate cut to boost the financial markets at the cost of a falling dollar and rising inflation be a wise trade-off?

 

There are many observers who think the main threat the United States will have to grapple with is stagnation with rising inflation, or stagflation for short. If so, then aggressive rate cuts will probably not help. In the 1970s, just after the 1973 oil crisis, monetary and fiscal policies that sought to increase employment by accommodating some inflation were found to be ineffective and the US laboured through a decade of stagflation.

 

Fed chairman Ben Bernanke last week said that a repeat is unlikely because conditions today are different, but markets are wary about placing too much faith in such declarations. In his Humphrey-Hawkins testimony to the US Congress last July, for example, Mr Bernanke forecast that the US economy would expand at a ‘moderate pace in the second half of 2007 and in 2008’ – a forecast which is now known to be wide off the mark.

 

Perhaps even more damning is this assessment of the sub-prime crisis delivered at the same setting – ‘. . . the current contraction in residential construction will likely restrain overall activity for a while longer, but as stocks of unsold new homes are brought down to more comfortable levels, that restraint should begin to abate’. Again, a prognosis which subsequent events have proved to have been painfully wrong. To be fair, the threat of stagflation – or even possibly a massive bout of inflation followed by a prolonged period of deflation – is probably the furthest thing from the Fed chief’s mind. Mr Bernanke now finds himself firmly wedged between a rock and a hard place, more so than ever before – the US dollar is crashing, oil is trading at an astonishing US$103 per barrel, the economy is at a standstill, consumer confidence and manufacturing are weak, commodity prices are soaring and the aggressive rate cuts of the past six months have not brought any relief to battered credit markets.

 

Cutting rates on March 18 by 50 basis points is the bare minimum that markets expect and will probably be shrugged off after a short while. A 100 basis-point reduction would probably trigger a mini-rally in stocks, but it would drastically reduce the scope for future Fed action and might even be interpreted as a move taken in panic. And, of course, to do nothing would be disastrous. With problems coming from all sides, handling the present mess would thus require every bit of central bank know-how Mr Bernanke possesses. For his sake, hopefully, stagflation won’t be another problem he has to tackle.

 

Source: Business Times

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