Monday, March 21, 2005

Inflation Pressures Become More Evident

Fed Governors are catching on to the fact that the problem the US economy is likely to face is inflation, rather than deflation. This despite the fact that job creation isn't exactly booming, wage pressure is low or non-existent, and monetary aggregates don't look like they're getting out of control. What, then, is the problem? The problem, of course, is that the way that the US has chosen to ease its excessive net foreign liabilities is to dilute the value of the currency. A lower dollar leads to higher oil prices, higher food prices, higher prices of imported goods and services, and if the Fed wants to keep the overall price level from rising at an accelerated pace, prices of services need to fall. Moreover, low US real interest rates are encouraging "carry trades" (i.e. borrowing in the US to lend in foreign countries, where the return on capital is higher), and these carry trades stimulate economic activity abroad.

In other words, the trade-off between inflation and unemployment has just become much more steep, after a decade or more of structurally declining inflation. When there are cost-push inflationary pressures that are unrelated to domestic demand, it becomes much more difficult to keep inflation in check while leaving unemployment untouched. Greenspan's successor is going to have a tough job. Fed Reconsiders 'Measured' Pace as Inflation Pressures Mount


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