Trained to fix the wrong problem

The problem is that there are a lot of bankers and economists who have spent their entire careers fighting inflation. That is what they are trained to do, find the first signs of inflation and hit it hard by pushing up rates. Those people are looking at the money supply expanding and expecting it to force up inflation at some point.

And they are right if you take a very big eventually in there. But the economy has to really recover first, and we are a long way from that. Inflation isn't very likely to take off until the economy gets going and unemployment goes down.

There is also a smaller, but influential, group of investment types who are hurt by the expanding money supply. The low interest rates in the US and the expanding money is causing the dollar to drop sharply, and this hurts some types of investments. For them, trying to get the government back to a real strong dollar policy with higher rates is just a matter of profits.

There are two big risks the Fed has to take into account. The risk of inflation if they leave rates too low too long, and the risk of killing recovery by pushing rates up too fast. Given the state of the economy, the first is small and the second large. Thus I think the Fed should wait until they see some actual inflation before raising rates.

The other concern the Fed has to consider is that printing this much money is crashing the value of the dollar. If the dollar gets so low that international investors begin to pull out of the dollar on a significant scale it will get ugly. But overall a weak dollar helps the US right now, so they want it as low as they can get it safely. Despite any claims by the government or the Fed otherwise, they like a weak dollar right now.

Jay

If I understand his view correctly, the weak dollar isn't a major concern now. E.g. http://www.prospect....ditorial_on_the_d

It is clear that NPR is unhappy with the deficit, calling it "unprecedented flood of red ink," which it compares to: "the previous record deficit was $459 billion and was set just last year." Serious reporters would have told listeners that the 2009 deficit was approximately equal to 10 percent of GDP. The previous post-World War II record was 6.0 percent of GDP in 1982. The actual records were more than 20 percent of GDP set during the war years.

The piece goes on to tell listeners: "the huge deficits have raised worries about the willingness of foreigners to keep purchasing Treasury debt." Yes, people worry about all sorts of things. Millions of people are worried that President Obama was not born in the United States. While some people no doubt have the worried that NPR notes, it might have been more informative to tell listeners that in spite of the large deficits, foreigners are willing to hold U.S. debt at historically low interest rates. This is very strong evidence that the foreigners are not worried.

It might also have been worth noting that if foreigners (notably China) stopped purchasing Treasury debt, then their currency would rise against the dollar. This would increase our exports to these countries and reduce our imports from them. In the case of China, this has been exactly the policy shift that both the Bush and Obama administration have been publicly demanding. It might have been worth providing readers with this information.

In other words, what determines the relative strength of the dollar is what it can buy compared to other currencies. A trade deficit has more impact on the value of the dollar than a budget deficit. Foreign capital that comes into the US to finance the budget deficit serves to keep the dollar stronger than it would otherwise be, or equivalently, keeps foreign currencies weaker than they would otherwise be. If the value of the Chinese Yuan increased, say, 50%, then China's export-fed growth would slow dramatically. They can't afford that, so they will continue to buy dollars for the foreseeable future.

As usual, things aren't as simple as they appear at first glance. The world economy is much more inter-connected than it was 25 years ago, so foreign governments can't simply decide to stop buying dollars. There are, of course, long-term costs in having foreigners finance our budget...

Cheers,
Scott.

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