The Fed: We need to aggressively raise interest rates in order to control inflation!
Also The Fed: Recession ahead!
Which is it?
Ordinarily the job of the central bank is to cut interest rates when there is risk of a recession and raise interest rates when inflation gets too high. But now we’re being told that we are at risk of inflation AND recession at the same time. What is the Fed supposed to do under these circumstances?
Back in 2008 I came up with an analogy to describe the predicament facing the world’s central banks. I compared the economy to a car driving on an icy road. Off the left side of the road lies recession/depression and off the right side lies inflationary crisis.
In ordinary times (when the road is not icy), the job of the Fed is relatively straightforward. Whenever the car starts to veer toward the left side of the road the Fed responds by cutting interest rates in order to stimulate the economy and avert the risk of economic contraction. Conversely, when inflation rises to unacceptable levels the Fed raises rates in order to slow the economy down.
But due to decades of mismanagement by both monetary and economic authorities, the normal economic cycle was not allowed to run its course. Ordinarily when companies take on too much debt or try to execute bad business plans they fail and go out of business. Management and employees lose jobs, investors lose money and resources get redirected to other uses. But since at least the late-1990s the Fed and the government have prevented this process from happening. By repeatedly bailing out failing businesses and pumping the economy full of excess liquidity, the necessary healing process never took place. Businesses that should have failed didn’t. In fact, many of them (specifically banks) got even bigger.
As a result the road started to get icy and treacherous. Unlike under normal conditions, when a road gets icy it becomes difficult and dangerous to make the proper adjustments. When the wheels lose traction the driver is forced to engage in riskier, more extreme corrective measures, and each of those course corrections increases the risk of crashing on the other side of the road.
This explains why we are at risk of recession/depression AND inflation simultaneously. Once the car begins to skid, it is nearly impossible to predict whether it will crash on the left side or the right side of the road. But the one thing you can say with a high degree on confidence is that it is extremely unlikely the car will regain traction and continue safely down the middle of the road.
Note: Unlike in the analogy, the Fed can choose which side of the road we crash on. Faced with the risk of economic collapse, they can print money without limit. Of course doing so exacerbates inflation, but history tells us that when faced with a choice between economic collapse and currency debasement, governments always choose the latter. Debasing the dollar can neutralize one of the main causes of economic weakness — i.e. unsustainable debt. Inflation reduces the real value of existing debts by allowing borrowers to repay their debts with money that has less purchasing power than when they borrowed it. Taken to the extreme of hyperinflation, debtors can essentially discharge their debts for free (e.g. Weimar Germany).
Of course there are enormous negative consequences to eliminating debt via currency debasement. The real value of savings evaporates. People living on fixed incomes get crushed as the purchasing power of their incomes decline. But ultimately the primary cause of the contractionary forces — i.e. debt — gets eliminated, thus creating conditions under which the economy can rebuild.*
The era of dollar hegemony will likely come to a close if the authorities take this approach. For the past century, anyone anywhere on earth who had excess wealth that they wished to preserve was likely to use the dollar for this purpose. For this reason the dollar is viewed as the ultimate “safe haven” and is the world’s reserve currency. But we already see signs that this dynamic is changing. Whether it be BRICS countries conducting trade in their own currencies or the emergence of cryptocurrencies, people are increasingly looking for alternatives to the dollar. If/when the Fed is forced to resort to even more extreme loose-money policy in order to avert a deflationary collapse, this will greatly accelerate this trend which is already in motion.
* In fact, one lesson that history teaches us over the course of thousands of years is that the exponential nature of the growth of compound interest ALWAYS requires some kind of extraordinary debt elimination. It is mathematically impossible to keep up with the growth of debt, and the amount of debt therefore grows like a cancer until it overwhelms the real, productive economy. There are various ways that have been used throughout history to eliminate unsustainable debt burdens, from bankruptcy to debt jubilees to wars. The one thing that is not possible is an orderly discharge of exponentially growing debt.
Josh, check out parity economics at NORM national organization for raw material economics as another way to deal with the problem.