The Cusp of Worldwide Inflation: How the Federal Reserve Is Making the Global Economy Less Stable
McKinnon, Ronald, The International Economy
What do the years 1971, 2003, and 2010 have in common? In each case, an easy U.S. monetary policy was accompanied by a weakening dollar-as with the dramatic Nixon shock of August 1971 when the other industrial countries were all forced to appreciate against the dollar. In all three cases, low U.S. interest rates and the expectation of further dollar depreciation led to massive "hot" money outflows from the United States. The world, then as now, is on a dollar standard where most goods entering foreign trade are invoiced in dollars. Thus, in all three cases, foreign central banks intervened heavily to buy dollars to prevent further appreciations and losses of international competitiveness against their neighbors.
When any central bank on the dollar standard's "periphery" issues base money to buy dollars, domestic interest rates are forced down and domestic inflationary pressure is generated. It may try to sterilize this monetary expansion and/or impose controls on capital inflows, but these measures are hard to enforce. The relevant periphery in the monetary expansion of the 1970s was the pre-euro countries of Western Europe plus Canada and Japan, whereas today it is more the high-growth emerging markets of Asia (China, India, and a host of smaller ones) and of Latin America (Brazil, Mexico, and so on). If most peripheral central banks expand simultaneously, the result is generalized worldwide inflation.
Primary commodity prices register enhanced inflationary expectations more quickly because speculators can easily bid for long positions in organized commodity futures markets. Excluding oil, Figure 1 shows the surge in the dollar prices of primary commodity prices in 1971-73 coincident with, and following, the anticipated Nixon shock of 1971. Figure 1 also shows the initial commodity price surge during the Greenspan-Bernanke shock of 2003-04, when the federal funds interest rate was reduced to an unprecedented low of just 1 percent followed by a falling dollar (with U.S. government encouragement).
Now with the Bernanke shock, where the Fed has set U.S. short-term interest rates at essentially zero since September 2008 followed in 2010 by two rounds of quantitative easing to drive down long rates, Figure 1 shows primary commodity prices in 2009-10 surging once again. Just in 2010 alone, all items in The Economist's dollar commodity price index rose 33.5 percent, while the industrial raw materials component soared a remarkable 37.4 percent.
The longer-term inflationary and economic consequences over the next decade of this most recent U.S. loose money shock remain to be seen. But we can glean useful hints by looking at the aftermaths of the two earlier shocks. In the 1970s stagflation, CPI inflation combined with cyclical bouts of unemployment and wide swings in exchange rates seemed intractable. Productivity growth in the mature industrial countries fell sharply.
A necessary but savage disinflationary policy in the early 1980s, where Fed Chairman Paul Volcker imposed extremely high interest rates (the Fed funds rate touched 22 percent in July 1981), ultimately succeeded in killing the inflation and inflationary expectations. With credibility in America's long-run monetary policy restored, hot money, which had flowed out in the inflationary 1970s, came back with a vengeance. The dollar soared in the foreign exchange markets and became extremely overvalued by the end of 1984. To prevent even more precipitous depreciations of their currencies, foreign central banks were forced to sell dollars and let their domestic money supplies contract. …