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The inflation freight train

Scott Jagow Aug 27, 2009

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.

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