Wednesday, June 11, 2008

Monetary policy and inflation

The current price pressures we are feeling are rooted in oil. Oil prices have been rising on a combination of factors: limited spare capacity, strong global demand, monopolistic forces (the Saudis and the Russians) and index fund investment. Furthermore, we linked the price of food to oil as a result of the biofuels policy.

Just as the Fed did not create the global tightness in the oil supply as a result of low interest rates, it will not cure it via high interest rates. There will not suddenly be new discoveries of oil if the Fed puts the Fed funds rate back to 5.25 percent. And raising the funds rate to 10 percent will not cause the world to be awash in oil.

The Fed will, however, destroy the economy if it reverses course and hikes rates. The cure will be worse than the disease.

Please read Joseph Stiglitz's eye opening article on the failure of inflation targeting. Professor Stiglitz is the 2001 Nobel Prize winner in Economics.

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