Mises Daily Blog: Macro Confusion: Inflation, Commodities and the Fed

12 05 2011

On the Von Mises Institute Daily index is an article by Kel Kelly dated May 12, 2011 on general macroeconomic misunderstanding of the root causes of our current economic situation.  The article can be found at the following web reference:

http://mises.org/daily/5273/Macro-Confusion-Inflation-Commodities-and-the-Fed

Following are a few key sections that are particularly relevant to today’s concerns about commodity price inflation and the role or economic impacts of monetary actions by the U.S. Federal Reserve bank.

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Will the Fed Raise Rates?

The discussion began with CNBC’s in-house economist Steve Liesman discussing whether the Fed should raise rates in response to reports of soaring wholesale inflation numbers. He explains that the Fed “has so far concluded that it would be the wrong medicine right now for the problem.”

That alone brings us the first concern: It is difficult to imagine that the Fed has actively decided not to raise rates, when the fact is that — as things stand — it could not raise rates even if it wanted to (and it might want to). It can raise treasury rates by ceasing to buy treasuries, but it can’t raise the federal-funds rate.

The Fed raises the federal-funds rate via open-market operations that withdraw money from the federal-funds market, making money more expensive. But given the massive amount of excess reserves that the banks hold at the Fed, it is virtually impossible for the Fed to withdraw all the reserves it has created without causing massive economic damage. Therefore, it is the excess money on the market that is keeping rates near zero. Thus, the banks — not the Fed — are in charge of interest rates.

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Regarding the root cause of commodity price inflation, Kelly writes…

But the demand for commodities and the prices of other goods have not been falling. Why? Because what is driving up commodity prices — while the prices of all other goods are rising at the same time — is simply an increase in the quantity of money. Market participants are bidding up the price of commodities, along with consumer goods and stock and bond prices (and, formerly, real-estate prices) with the additional money they are receiving from the central bank.

Rising asset prices are the manifestation of inflation. The prices of financial instruments and commodities are rising more rapidly than consumer prices because they are traded on exchanges, where banks, insurance companies, hedge funds, and the like insert funds newly borrowed at cheap rates from the world’s central banks. Further, foreign central banks themselves redirect reserves earned from the US trade deficit into the financial markets. Therefore, new money flows disproportionately into the asset markets relative to the real economy.

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Regarding Fed policies and the impact on commodity prices….

The Fed officials are saying that if they raise interest rates and/or reduce money supply growth, the economy will slow. They are therefore saying that the economy is being driven — or at least pushed along — by low rates and by money and credit “being available” (as they would say). Therefore, the growing economy, in their view, causes a “demand” for commodities. They don’t say that it is a monetary demand — just a general “demand.”But they also acknowledge that if this demand were reduced with “monetary policy tools,” demand for commodities would fall. Thus, they are simultaneously saying that their policies are not driving commodities prices higher, but that if they undo their policies, commodities prices will fall. The fact is that it is their money pumping that is driving both GDP growth and commodities prices — but not the real economy.

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All this is food for thought in regards to the impact of Fed policies based on Keynesian economic theory on commodity price inflation – as we have seen both ups and downs in recent weeks and months.

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