University of Oregon economist Tim Duy is rapidly becoming one of my favorite reads. His insight into how loosey goosey low interest rates in the US have engendered blowback unforeseen by the Fed is a great example:
For my part, I am concerned that the Fed appears to have written off the dollar. My concern stems from rising international tensions - the Fed is dumping additional liquidity into the system at a time when most central banks are attempting to turn off the faucet. The Fed is implicitly, if not explicitly, relying on countries with fixed exchange rates to absorb that additional liquidity at the cost of inflation in those economies. Moreover, those economies with floating rates become the anti-Dollar bets.…
…. the Fed is forcing their foreign counterparts down one of two paths - either central banks with appreciating currencies throw in the towel and match Fed rate cuts, thereby unleashing a fresh wave of global liquidity, or central banks with fixed exchange rate finally decide that they can no longer bear the inflationary cost of supporting the US current account deficit.
Several other commentators have made similar points and/or refined Duy's argument. A discussion of all of their arguments can be found at naked capitalism.
His point, simplified and in more basic english is, when the US floods the world with money, other governments can react by either (a) raising their own rates to forestall inflation, which will choke off their own growth, or (b) matching our easy money policies, which will only add to inflationary pressures in their own countries. BUT, if they opt to continue to peg their currencies to the dollar, the inflation they create gets re-imported back into America, creating stagnation here.
An example of the "anti-dollar bet" can be found in Europe:
European bonds fell yesterday, pushing two-year yields to the highest in seven years, after European Central Bank President Jean-Claude Trichet said an interest-rate increase in July is "possible.''
As a result, countries such as Australia, UK, Japan, Germany. and Brazil, with appreciating currencies vis-a-vis the dollar have yield curves in inversion, a strong sign of an impending recession.
The choices confronting other, dollar-linked countries have shown up across Asia, Africa and Latin America in this week's headlines.
When another dollar-linked country like China matches or at least simulates the Fed's rate cuts (and China's interest rates, like the Fed's, are quite low at this point), that creates an inflationary boom in those countries. Thus, in China for example, you now have ~8.5% year over year inflation, and pressure on wages to match that inflation. This is a classic wage-price inflationary spiral such as the US saw in the 1970s. Similar paths have been taken by the petrosheikhdoms, leading to double-cigit inflation rates in those countries.
In a host of other countries, interest rate hikes to at least partially ameliorate inflation have come fast and furious:
Japan's government bonds fell, pushing 10-year yields toward the highest since August, on speculation quickening inflation will prompt central banks to increase interest rates.
two days after Bank of Japan Governor Masaaki Shirakawa said the BOJ's accommodative policy may encourage ``excessive risk taking.'' Expectations for price increases, as measured by inflation- protected bonds, rose to the highest since August.
``Rate increases by central banks in Europe and the U.S. will put pressure on the BOJ to move sooner rather than later, leading to a sell-off of debt,'' said Koji Ochiai, a senior analyst at Mizuho Securities Co. in Tokyo.
India's inflation jumped to 8.24 percent, the fastest since August 2004, adding pressure on the central bank to raise interest rates.
Australia's dollar headed for a weekly gain on prospects its central bank will raise interest rates. New Zealand's dollar may fall for a second week on speculation its central bank will lower borrowing costs.
South Africa's central bank would risk stalling economic growth if it raised the benchmark interest rate by another 2 percentage points, as mooted by Governor Tito Mboweni last week, said FirstRand Bank Ltd.'s Chief Executive Officer, Sizwe Nxasana.
The Johannesburg-based bank expects the Reserve Bank to raise its key rate a half point when policy makers next meet on June 12, slowing economic growth to about 3.5 percent this year, Nxasana said in an interview with Bloomberg TV televised today.
Mexico's yield curve issteepening on increased inflation expectations.
The [Brazilian central] bank's monetary policy committee, Copom, voted unanimously to increase the so-called Selic rate to 12.25% from 11.75%, as expected. The hike came after a three-year run of lowering borrowing costs.
Indeed, outside of the US, Canada, and the UK, virtually every other country in the world is raising interest rates.
Here's a graph of yield curves for a host of Asian countries, showing steepening yield curves anticipating more inflation in those countries which have held rates lower than their inflation rates, and flat to inverted yield curves anticipating recession in those countries with higher rates vis-a-vis inflation:
But in the US itself, the story is different. As Professor Krugman points out, the "wage" part of the spiral is missing:
It’s true that the soaring prices of oil and other raw materials have led to public anguish over the rising cost of living. But ... there’s no sign whatsoever of the wage-price spiral that, in the 1970s, turned a temporary shock from higher oil prices into a persistently high rate of inflation....
At the time,... many workers were getting comparable contracts. Workers and employers were, in effect, engaged in a game of leapfrog: workers would demand big wage increases to keep up with inflation, corporations would pass these higher wages on in prices, rising prices would lead to another round of wage demands, and so on.
Once that sort of self-sustaining inflationary process gets under way, it’s very hard to stop. ...
. ... Consumers are worried about inflation, but you have to search far and wide to find workers demanding ... higher wages, let alone employers willing to accept those demands. In fact, wage growth actually seems to be slowing, thanks to the weakness of the job market.
And since there isn’t a wage-price spiral, ....[w]hen the surge in commodity prices levels off — and it will; the laws of supply and demand haven’t been repealed — inflation will subside on its own.
Last week The Economist summarized this situation as follows:
Taken as a whole (and using official figures), the average world inflation rate has risen to 5.5%, its highest since 1999. The main cause has been the surge in the prices of food and oil, which briefly soared above $135 a barrel this week....
By slashing interest rates as inflation has climbed, has the Fed sowed the seeds of a new inflationary era? That case looks hard to prove in the rich world. Inflation rates of 3.9% in America and 3.3% in the euro area are far higher than central banks want, and inflation expectations are rising... . Yet so far there is little sign that higher food and oil prices are pushing up other prices in the rich economies. Wages have remained relatively subdued ....
The picture is very different in emerging countries. Prices are rising much faster partly because food accounts for a bigger chunk of their consumer-price indices. But wages (rising at nearly 30% a year in Russia) and core-inflation rates are also accelerating. Many of these economies are operating close to full capacity, where inflation is more likely to take hold.
There are alarming similarities between emerging economies today and the rich world in the 1970s when the Great Inflation lifted off. Many policymakers in emerging markets view the rise in inflation as a short-term supply shock and so see little need to raise interest rates. Instead they are using price controls and subsidies to cap prices. Money supplies are growing almost three times as fast as in the developed world....
In order to forestall a banking and investment house collapse in the US, the Federal Reserve has flooded the world with liquidity/money. This has ignited wage-price spirals similar to the 1970s throughout the developing world. In the developed world, however, and especially the US, where wages are stagnant, this inflationary spiral has revealed itself in the prices of goods which are necessities that are set globally (food, oil/gas) spiraling upward, causing strong deflationary pressures on goods and services priced domestically, as American consumers cut back on other, more discretionary spending.
This is all part and parcel of the slow, long-term ratcheting down of the standard of living for average Americans.