Professor Schaff argues against lowering interest rates in order to head off recession. I am not sure he is wrong, but I think we need to distinguish between two causes of inflation. One is when the supply of some set of basic goods is suddenly reduced or, what is the same thing, becomes more expensive. Rising oil prices and food prices world wide would seem to examples of this. If you allow the prices to rise, eventually the supply will increase. Professor Schaff directs us to this article, from the Kansas City Star:
If you’re seeing your grocery bill go up, you’re not alone. From subsistence farmers eating rice in Ecuador to gourmets feasting on escargot in France, consumers worldwide face rising food prices. Freak weather is a factor. But so are profound changes in the global economy, including higher oil prices, lower food reserves and growing consumer demand in China and India.
In the long term, prices are expected to stabilize. However, consumers still face at least 10 years of more expensive food, according to preliminary FAO projections. As of December, 37 countries faced food crises, and 20 had imposed some sort of food-price controls.
That is basically what has to happen. Food-price controls will result, due to very mechanical laws, in shortages. Meanwhile, food production will gradually catch up with demand.
The other cause for inflation is when the money supply rises faster than the supply of goods. This happens when governments literally print money, or by some other means pumps funds into the economy faster than production can soak up that money. As folks buy goods up faster than they are produced, the price on the remaining goods naturally rises. That second thing is what we usually mean by inflation.
Now here is my problem with the argument advanced by Professor Schaff, and he is hardly alone: an inflation threat doesn't really seem to go very well with the crisis in the housing market. Home prices are falling dramatically, which means 1) the supply of this very basic good is exceeding demand; and 2) a big chunk of the dollars that people thought they had stored up in their homes is rapidly disappearing. Shouldn't that reduce inflationary pressure?
Secondly, how much evidence of serious inflation is there in the system. Here is a chart from Inflation Data.Com, showing the general trends from 1990 to the present:
While it is true that the inflation rate in the last four months has been high for the last decade, the average of 2007 was actually lower than 2005-2006.
The question then is whether certain sectors of the economy suffer from a "liquidity crisis," i.e., there is nothing fundamental wrong except that they are short of cash. In that case, an infusion of cash in the form of lower interest rates can make sense. Since 1980 the Fed has been pretty good at this sort of thing, and I am inclined to give Bernanke the benefit of the doubt. See Lawrence Kudlow on this.
So right now the so-called median home price is $196,000, roughly back to 2004 levels. And it's still about 60 percent higher than ten years ago. (Studies show homeowners generally don't sell for about a decade, so I use ten years as the comparison.) But here's where Gentle Ben comes in. A $196,000 home and a 10 percent equity down payment leaves $176,000 to be financed, perhaps with an adjustable-rate mortgage. And since the Fed slashed its target rate and LIBOR rates dropped roughly in sync, the owner of this median-price home is now saving $300 a month compared to last summer, or about $3,600 a year.
That's a big rebate from the Fed. It's about three-times bigger than what Uncle Sam is promising. The official IRS notice says the average married couple filing jointly may get $1,200. But Fed head Bernanke is giving median homeowners $2,400 more than that amount. A lot better, right?
In other words, the Fed is responding to a crisis in housing (a crisis for sellers, not for buyers) with modest help for buyers and others. The action is within the parameters set by the last decade, and so is unlikely (of itself) to trigger major inflation. It might be the trick needed to avoid a recession, which everyone talks about but so far has quite shown up.
I would certain prefer this to targeted actions by Congress that bail out this or that economic player, and run the risk of convincing everyone that future bad decisions will have no adverse consequences.
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