Just a brief follow-up on yesterday’s post on Alan Greenspan. Sleeping on it I have the feeling that for blog posting I may suffer from the failing of trying to complicate things too much, or at least of trying to say too much at once.
Really there were two central themes, and since they are a little different from what most other commentators are saying it may be worth trying to drive them home.
The first point is perhaps best illustrated by this little extract from a Reuters article:
A Reuters poll of 20 of Wall Street’s top firms — primary dealers authorized by the Fed to deal directly in government securities markets — found all anticipate another quarter-percentage-point increase to 1.5 percent on Tuesday.
“Given the mind-set in the markets that another increase is coming, the Fed is unlikely to wish to disrupt that expectation at this stage,” said economist Lynn Reaser of Banc of America Capital Management Inc. in St. Louis, Missouri.
“There might in fact be a greater risk to the economy in the Fed’s holding back simply because to do so would raise questions about what does the Fed know about the expansion’s health,” she added.
Now Let’s be absolutely clear: this view is totally eroneous.
The greater risk to the US economy doesn’t come from the Fed’s holding back in raising rates, but from the Fed bowing to market pressure to raise them when they should know better. It is not the Fed which has to adjust the rate to appease the financial markets, but the market participants who have to get their expectations back into line with a complex reality. The dangers of raising rates too quickly in anticipation of strong growth which doesn’t come are only too clearly illustrated by the Japanese experience in the 1990’s. Prudence, or downside-risk hedging, suggests it is far better to err on the side of easing than to tighten unnecessarily. Is that clear enough?
The second key issue is the so called ‘inflation problem’. This ‘problem’ is not what it sems to be. The issue is a ‘terms of trade’ one. Some parts of some key developing economies are growing extraordinarily rapidly, and this is putting a price squeeze on certain key resources, this is not the same thing at all as a general and pervasive inflation problem.
Some economists like graphs and equations: I work with images. To conduct this simple thought experiment you will need three things: an index finger, a pencil and a thick elastic band. Now string the band round your finger, insert the pencil and begin to stretch at a constant pressure. What happens? At first the band stretches, then you reach a point where you can’t stretch more, then your index starts to feel sore and you relax your grip slightly, with the pencil moving back in. Get the picture? Well no analogy is perfect :).
Now imagine that the pencil is the economy of Guandong Province in China (neo-classical economics adores partial analysis so lets keep this really simple), your index is the OECD block economies, and the rubber band is (of course) the market value of oil futures. Essentially the ebbs and flows of oil (and other commodity) prices act as a semi-automatic regulatory mechanism on global growth rates. The scarcity of these resources means that potential growth rates are lower than they would otherwise be.
This is a new factor to take into account in economic management of the OECD economies. What does it mean? Well if you swallow the inflation scare argument it means you need monetary tightening to head it off. And if, like me, you don’t buy this one, then you need a recalibration of your management tools, you need a relatively higher level of monetary easing (other things being equal) than you would have needed without the resource squeeze.