Ben Bernanke Will Try and Fail to Stop Inflation

Posted on March 25th, 2009 by admin in Political Economy

Ben Bernanke is like Indiana Jones fighting his way to nirvana. Ben first has to slay the ferocious deflation monster and if Ben survives that fight, his reward is to hurtle forward to wrestle with the inflation anaconda. For old Ben that will be the fight of his life, because his weapons are fragile and he doesn’t know it. At this point in his hero’s journey, Ben doesn’t care about the inflation anaconda anyway, since the deflation monster is all he cares about now. But he thinks inflation can be killed or contained later. He’s wrong, and that’s a huge problem for our economic future. Get ready for inflation.

Government bureaucrats implicitly assume they can apply their policies to control the economy and produce various important economic conditions. These planners believe they can target the economy to produce X jobs, or Y inflation rate, Z money supply. The primal reason for planner failure arises from the random durations (“lags”) between policy actions and results. By the time results are measured and revised, the economic situation has changed, and the next action applies to a deceptive state.

So after the stupefying amount of money the Fed pumps into the economy to fight the deflation monster is absorbed, deflation will be dead…but inflation will emerge. Ben’s fantasy is that he can deal with that later by raising interest rates. Yes, he will, but he must fail from poor timing.

Here’s a great piece in the Wall St. Journal today that starkly illustrates these policy errors in the UK.

Taking Air Out of Deflation Plan
WSJ 3-25-09, pC12
By SIMON NIXON

Deflation? What deflation? The U.K.’s February inflation figures make embarrassing reading for the Bank of England, just days after it started printing money to head off a deflationary threat. Instead of falling, consumer prices actually rose 3.2% year-on-year.

Since that is more than 1% above the BOE’s inflation target of 2%, BOE governor Mervyn King was obliged to write a letter to the chancellor of the Exchequer explaining what went wrong.

The answer appears to be the BOE has underestimated the inflationary impact of the sharp decline in the value of sterling.

Does this mean the BOE was wrong to embark on quantitative easing? Not necessarily. That policy is as much about trying to address illiquidity in credit markets as tackling deflation. Besides, the BOE still expects inflation to fall back below 2% later this year as the impact of lower energy bills feeds through.

But it does suggest the BOE mightn’t do as much quantitative easing as expected, and will need to withdraw much of the stimulus as soon as the crisis ends. That is good news for the pound. The risk is that tightening policy so soon after the crisis ends will choke off a recovery. The best way to mitigate that scenario would be for the U.K. government to tighten fiscal policy instead. Unfortunately, that looks like a forlorn hope.

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