Update 4 Jul 2008: see a fuller answer to this question at my new post: The ECB is right and the Fed is wrong
That’s the question Ambrose Evans-Pritchard addressed in his blog yesterday. I am firmly in the deflationist camp, meaning systemic risk from credit contraction is the most frightening risk for our economies. However, I believe that allowing inflation to rise exponentially does risk a potentially greater collapse once central banks are forced to react. Better to put the inflation genie back in the bottle now.
Evans-Pritchard takes a different view, praising the easy money policy of the Fed and criticising the ECB. I agree with him that this is not that 70s Show. It is more like that Japanese show or that 30s show. But, I don’t agree with him about the Fed being the better central bank here. Nevertheless, I do respect his arguments and he has shown great insight in previous posts.
Below is the beginning of Evans-Pritchard’s post.
Sadly, we are witnessing the sort of strategic errors that turned the recession of 1930 into a global catastrophe.
The European Central Bank is now hell-bent on a course of action that will have a knock-on effect across the world and risk a dangerous implosion of the credit system.
The ECB’s Jean-Claude Trichet told Die Zeit today that “there is a risk of inflation exploding.”
Let me put it differently: there is a grave risk of social and political disorder “exploding” if the logic of his argument is followed to its grim conclusion, that is to say if the ECB charges ahead with a string of rate rises through the autumn after its move to 4.25 per cent today.
The ECB mantra is that Europe and the world is on the cusp of a wage-price spiral along the lines of the 1970s. This directly contradicts Ben Bernanke at the Fed, who insists — correctly — that today’s conditions are not remotely like the 1970s.
(Perhaps this is uncivil, but I might add that Bernanke is one of the greatest economists of our age. Trichet studied political administration at ENA. He is a fine and honourable man, but he is a politician, not an economic historian)
Yves Smith over at naked capitalism makes a more compelling argument regarding the Fed and ECB policy. She says:
Readers have taken to throwing brickbats when I post material that suggests that raising interest rates (at least in advanced economies) might not be a good move right now.
We’ve said before that the reason the Fed kept rates too low too long was it looked at inflation as strictly a domestic phenomenon and ignored the inflation-suppressing effects of cheap imports. That process has gone into reverse due to high oil prices and rising import prices. Remember, the reason high interest rates kill inflation is by slowing economic activity. That’s already happening, and I am highly confident things will get worse all by themselves if the Fed and ECB merely stand pat.
The problem is inflation in emerging economies, particularly China. The Chinese stock market (not a perfect indicator, to be sure) says growth is slowing big time. We noted in a post yesterday that there are other indicators, such as significant factory closings, that say Chinese growth may be about to downgear fast. We’ve noted in passing, and reader Independent Accountant noted longer form, that an increase in fuel prices is having the same effect as tariffs. Hello, Smoot Hawley?
–naked capitalism, 3 Jul 2008
I suggest you read her post. My own view is that we have a pseudo Peak Oil situation. That is to say the available cheap oil given previous exploration and production is less than the total demand for oil. As a result, prices are going to go through the roof until the economy responds with demand destruction. Investment in the oil sector cannot take place quickly enough to be a relief valve for this situation.
(Whether we will ever be able to produce enough light, sweet to meet demand is questionable. I believe productive capacity has peaked and we need to find alternative sources or use technology to better extract the residual oil in existing fields. That will be expensive. But that’s a debate for another day.)
In my view, this is the reason for oil prices rising so high and is behind much of the inflation we see in oil and food. While I do believe this is temporary due to demand destruction, we do risk a wage-price spiral if this situation remains ‘temporary’ for too long. A few years ago, Stephen Roach thought you might have seen demand destruction at $70 a barrel. But here we are at double that level.
As credit contraction is the main economic worry over the long-term, raising rates once the inflation genie is out of the bottle and a wage price spiral has taken form is a recipe for disaster. The ECB, the BoE, the Fed, and other central banks are, therefore, faced with the unpleasant dilemma of deciding whether the wage-price spiral is likely to happen and to make their bets accordingly now. Waiting could be disastrous.