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Saturday, August 05, 2006

Fed Policy and Inflationary Pressures from Import Prices

knzn says Brad DeLong is "is going out on a bit of a limb":

Not the End of the World, by knzn:  Now that we’re going to have a recession, the question arises as to how we are going to get out of it. “With great difficulty,” seems to be the consensus. Getting out of a recession is seldom easy, but I think some commentators have exaggerated the difficulties involved this time around. In particular, Brad DeLong (quoted by Mark Thoma) is pessimistic about the options the US would have available should it fall into a recession (for which he puts the odds at about 30%, although he doesn’t make much of a case for the remaining 70%). The rest of this post reproduces (on mvpy's suggestion) a comment I made on Mark Thoma’s entry above. First, citing Professor DeLong regarding the prospects for a monetary solution:

… sharp reductions in interest rates would lower the value of the dollar and increase inflationary pressures from import prices in a way that the Federal Reserve does not dare allow.

This is a controversial point, and Brad is going out on a bit of a limb here. First of all, many imports are priced in dollars, and many of those that aren’t literally so are effectively priced in dollars because the prices get adjusted according to the prices of dollar-priced competitors. Brad remembers as well as anyone how adamantly foreign producers tried to defend their US market shares during the dollar declines of the late 1980s.

Second, policymakers in foreign countries that depend on US demand or compete heavily with the US aren’t likely to allow dramatic appreciation in their currencies. The Asian countries just won’t let it happen. Europe may let it begin to happen, but when their economies start to decline due to US competition and their inflation rates decline due to a strong Euro, the ECB will ease up and allow the dollar to appreciate again (and, in fact, traders will anticipate this action and forestall a dramatic rise in the Euro to begin with). Moreover, the Fed will anticipate these foreign responses and therefore will not be tremendously concerned with the value of the dollar until they actually see the inflation rate rising because of it (which it may never do, for this and all the other reasons described here).

Third, with the US economy in recession, with the Fed’s inflation-fighting credibility high (as it will be, if the Fed manages to cause a recession), and with an extremely weak US labor market (much weaker, because of the recession, than the already very weak labor market today), there will be dramatic domestic disinflationary pressures to offset any inflationary pressure from imports.

Fourth, in the event of a US recession, those imports (such as oil) that have volatile prices will (along with everything else) experience a drop in demand, which will put downward pressure on prices and tend to offset the effect of the weak dollar.

Finally, to the extent that import prices do rise, and export prices fall in terms of foreign currencies, this will be an excellent stimulus for the US economy. Like any economic stimulus, a weak dollar also tends to be inflationary, but it is not reasonable to assume that its inflationary impact would be out of proportion with its stimulative impact. You wouldn’t say, “Sharp reductions in interest rates would increase demand for building materials and construction workers and thus produce inflationary pressures that the Fed doesn’t dare allow.” During a recession, the Fed does dare allow inflationary pressures, because they are offset by the disinflationary impact of the recession itself.

    Posted by on Saturday, August 5, 2006 at 02:11 PM in Economics, International Finance, International Trade, Monetary Policy | Permalink  TrackBack (0)  Comments (7)

          

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