HowTo: deal with inflationary economic contraction

This is a shorter-than-intended post. WordPress lost the first one, and I’m just not that into doing it all twice.

I mentioned this in class today (going so fast that I’m not sure anybody heard anything, at all – end of semester dash).

Ben Bernanke put the Federal Reserve on a path towards a December rate cut in a speech on Thursday night in which he said the relapse in financial markets had resulted in a “tightening in financial conditions” that had the potential to harm the real economy.

The Fed chairman also said recent data on household spending had been “on the soft side” and warned that the combination of higher petrol prices, the weak housing market, tighter credit conditions and declines in stock prices seem likely to create some headwinds for the consumer in the months ahead.

Fortunately (for me, and probably only for me, and even then only with respect to having been right all semester), the Fed is, by all appearances, openly addressing its conundrum: Fiscal policy having done very little, it is left to Monetary policy to push along the economy – not one of its better uses – but, worse, trying to boost the economy while also containing inflation. This is something we like to call impossible. The short version: here is a business cycle, from the ever-helpful site tutor2u:

Inflation and Unemployment occupy different spaces. In the Slump/Recession part of the cycle, Aggregate Expenditure is low, i.e.:

Aggregate Expenditure = Consumption + Planned Investment + Government Purchases + Net Exports

is less than

GDP = Consumption + Actual Investment + Government Purchases + Net Exports

We have unplanned investment, or an unplanned increase in inventories. Result: people start getting laid off, as we stop selling/making so many goods and services.

Yes, I still hate Economics’ obsession with ”un”. Oh well.

At the other side of the business cycle, the opposite is true. We are selling more goods and services than intended, with an unplanned decrease in inventories. So we hire more people, we pay overtime, we run our factories longer during the night. We have to compete for factors of production: pay higher wages, pay higher input prices. Here inflation is the problem: higher wages, highe input prices mean higher final prices; higher prices mean higher wage demands, etc.

The government has two basic sets of policy for macroeconomic management: fiscal and monetary. Fiscal is government purchases – increasing expenditure or cutting taxes (for a slump). Having blown the whole thing on tax cuts it couldn’t afford and a war it couldn’t afford (and one that, bizarrely, is doing very little to help the economy), fiscal policy is pretty-well ‘no-go’ for the time being.

This is already a problematic situation, because one prefers not to have only one policy tool. Particularly since Monetary is not nearly as good at direct boosts to economic activity. It has a long tail, can very easily be overdone – thereby causing the next dis-equilibrium to be worse – and is evermore subject to capital market speculation, domestic and foreign.

Monetary policy is interest rates. The Fed buys or sells treasury bills (or makes myriad other interventions, these days), in order to reduce or increase the level of cash in the economy and, by decreasing or increasing the money supply, increasing or decreasing the interest rate (interest rates are the price of money: increase the money supply and the price goes down, and vice versa). So in a slump, the Fed lowers interest rates, increasing consumption and investment – principally investment, which is more variable than consumption anyway. In a boom period, it does just the opposite.

What does it do when it faces both? It wishes it had never taken the job.

Managing inflation and unemployment simultaneously is practically impossible. Managing it with the same policy tool is impossible. Inflation and unemplyment are not supposed to occur at the same time – one can see the current situation as a combination of endogenous factors – bad macroeconomic management, bad financial sector regulation – and exogenous factors – low agricultural yields, declining oil supplies/exports. The economy just cannot be boosted and restrained at the same time.

This, for example, is my idea of why China is so happy with its low Yuan. It cannot deal with unemployment, so it will accept high inflation, so long as it means 150m Chinese people have the surplus jobs.

In the US, the situation may not be that different. One of the advantages of continuing to use core inflation long after it made much sense is that two interest rate cuts with inflation is daft: 2 interest rate cuts with steady core inflation is fine. It is convenient for the Fed to pretend, as long as possible, that one problem just doesn’t exist, because it’s the only way it can attack the other.

Back to the story, then:

… new revised figures showed the US economy grew at its fastest rate in four years in the third quarter. An export surge fuelled by a weaker dollar and global growth more than offset the impact of the deepening slump in housing.

Gross domestic product grew at 4.9 per cent in the quarter, almost twice the Federal Reserve’s estimate of the maximum sustainable rate for the US economy.

However, a sharp rise in inventories reinforced fears of weak fourth-quarter growth.

Working backwards: A ‘’sharp rise in inventories”: unless that was a planned sharp rise in inventories, I’m going to take that as indicative of further weakness in an already soft economy. Meaning unemployment. Meaning, yes, expansionary macroeconomic policy. Such as it is possible with increasing prices. Hence the next part. A 4.9% increase in GDP: with unplanned increases in inventories, we’re making things but not selling them – so that can’t last.

However. GDP = P x Q. Therefore ΔGDP = ΔP x ΔQ. Some of the change in GDP is ΔQ, but some of it – I’m guessing a significant amount – is ΔP. From the Burea of Economic Analysis:

One can see, first, how Net Exports is becoming more and more important to our economy, these days. This will be why we hear Secretary Paulson always going on about a strong dollar, but never doing anything about it. We’re the new China, you see.

Second, Consumption expenditure is up, but flagging. Given that this includes transport, food, etc., it’s hard to imagine that this decline is that small. My guess is negative ΔQ coupled with positive ΔP – meaning the negative ΔQ will be a lot larger than these numbers appear.

This will be why the Fed is awaiting the latest matching data from the Burea of Labour Statistics: try to figure out how the employment and CPI numbers fit into the GDP data, to see just which of the two problems it should put above the other. Given the way capital markets are acting, and given that corporate profits are still high, overall (i.e. relative to previous history, not just earlier this year), I don’t see why rates should be cut again. Given the need for foreign capital in/by the US, honestly, cutting rates and hitting the dollar a third time is just as likely to hurt the economy, a little farther down the line.

We shall see, I suppose. The next BEA release is in a few weeks. The BLS employment numbers are due in a week (their last employment numbers were hardly positive, though); CPI numbers in a fortnight.