6
The inflation freight train
Just try stopping inflation once it gets some momentum. I tried this morning. The Federal Reserve has this cool Internet game that puts you in the Fed Chairman's seat for 16 quarters. Let me tell you what I did.
I started the game with the Fed's key interest rate, the Fed Funds rate, at .25%, where it is now. We're in the third quarter of a zero to .25% rate. The Fed has suggested it will have to stay there quite a while, some economists say into 2011. That would be two years -- or eight quarters -- at that low rate.
In my first scenario, I left the rate at .25% for 8 quarters, then I increased interest rates by a full point every quarter thereafter. It was too little, too late. Inflation soared. By the time interest rates reached 8.25%, inflation was zooming past 30% and showing no signs of stopping. Uh, I lost my job.
Next, I started with the same premise -- .25% for 8 quarters. Then, I started raising the funds rate by 3 full percentage points every quarter. Even gigantic steps like those did not stop inflation. It took a year and a half before inflation started coming back down. It peaked at 14%, but interest rates were 18.25%! I was fired again.
I played out a few more scenarios in which I left the rate at .25% for a shorter period than 8 quarters. Even after 5 quarters (remember, we're already at 3), those 1 point rate hikes for the next 11 quarters did virtually nothing. Inflation hit 14% and interest rates were all the way up to 11.25% by the end of that game. No reappointment for me.
Now, this is a simple video game. The real economy is obviously much more complex. And these are exaggerated outcomes. But it could be a lesson in how difficult Ben Bernanke's job might be. I know he says the Fed can react swiftly and get inflation under control, but what kind of interest rates will that require?
The unemployment rate is also a factor. If unemployment remains high, inflation is much less of a threat. A flood of money pouring into the economy is unlikely when 10% of the population is jobless.
Then again, what's wrong with a little inflation? I was talking to Reuters econ blogger Felix Salmon this morning, and he said we might need above-average inflation to chip away at the Debt Mountain we've built. The real amount of debt in the economy would shrink a bit.
Anyway, here's the link to the game, "So you want to be in charge of monetary policy?"
Play around with it. See what happens. See if you can keep your job.
Hat tip, Bloomberg.
I've tried it about 4 different times and if you keep the funds rate around 3% above the inflation rate then you can get reappointed! I wish it were this easy in real life!
Fun little exercise!
It makes me think of that quote you posted not too long ago.
“If the American people ever allow private banks to control the issuance of their currency, first by inflation, and then by deflation, the banks and the corporations that will grow up around them will deprive the people of all property until their children wake up homeless on the continent their fathers conquered.â€
-Thomas Jefferson
I don't understand why deflation is sooo bad? seems like a balanced response to overwhelming inflation through the years.
I remember from some of my economics classes the concept that some amount of inflation is a normal and necessary part of a growing economy. In fact one of my teachers stated that a capitalist economy can't (or won't?) grow if inflation is at or below zero. It actually made sense the way he explained it.
It's always maintaining that balance of the right amount of inflation that's tricky.
Very interesting indeed. I do agree with the inflation fear for 2011 and beyond, not driven by domestic factors (ample underutilization of production factors of both labor as manufacturing equipment will keep factor costs and prices down). It more the 'imported' inflation (commodities) and the decrease in demand for USD denominated fixed income (@ current rates) that will drive USD inflation. USD is strong as a safe haven for now, but in 2011 that save haven requirement will no longer play into USD strength and the greenback will compete with higher yielding currencies to finance the deficit. I am afraid this isn't going to be smooth sailing for Mr Benanke, wish him all the best.
