Why inflation outside the US is neither the Fed's fault nor its problem

There's been a lot of bellyaching around the world lately about the US and, to a degree, Europe exporting their loose monetary policies to the rest of the world and causing inflation. It's mostly the US that people complain about, and European commentators do their fair share of the complaining as well. An article in Der Standard, a daily paper based in Vienna, Austria, this week claimed that the US was attempting to solve its problems by pushing them onto others by devaluing its currency. The currency value is a separate (though related) issue, so I'll come back to that later.

World-wide rates of inflation are neither the US central bank's fault, nor are they something the Fed should really care about. Other countries' inflationary problems are just that: their problems. It may sound harsh, but it's actually not. It helps, too, that this is simply the truth.

The Federal Reserve, the US's central bank, has the responsibility of setting and targeting interest rates for the United States. Its concerns are ensuring price stability and low unemployment. Over the last few decades, it's done a pretty good job at both, though it definitely shares blame for the financial crisis and the high unemployment it caused. The past has been discussed enough here, however (see previous articles on the subject starting in 2008). The reason interest rates in America are at record lows is very simple: unemployment is high and core inflation is extremely low at 0.8%. Most banks in the rich world target rates of around 2%. The Federal Reserve is, very rightly, concerned about deflation at the moment. Deflation would mean falling prices. It is very dangerous because falling prices encourage people to save more and spend less, which causes prices to fall farther. This is because you would rather save your money a little longer, knowing that TV you wanted will get cheaper. Likewise, companies concerned about costs will be reluctant to invest, as the prices they can charge will fall in the future. All this makes spending now less appealing than spending later. Cue the vicious cycle of deflation and recession. Cue Japan since its financial crisis in the early '90s. What's more, interest rates cannot drop below 0%, meaning deflation would be extremely hard to fight once it got going. With unemployment high and people worried about the economy, booming demand is also unlikely to drive up prices. All good reasons for super low rates. This is the Federal Reserve's responsibility. If the US economy sinks into deflation, the whole world would suffer from that, too.

The reason the inflation in the rest of the world is not the Fed's problem comes in two parts. For one, it is simply not its mandate. More importantly (and less selfishly), however: other states can set monetary policies of their own independent of the Fed. It is only their reluctance to do so that is causing problems! Economic conditions vary around the world and call for varied monetary policies. Overheating developing countries should raise policy rates, allow their currencies to appreciate, and yes: instate capital controls. A good way to do this would not be caps, but rather taxes on capital inflows (as Brazil has done). This would make their currencies effectively more expensive, while not damaging exports or encouraging imports too much. This damage to exports and encouragement of imports is a worry for developing countries that are on the receiving end of cash looking for higher returns. (If cash inflows drive up the currency, the country's exports become more expensive and imports become cheaper.) It is a justified worry, but the solutions lie with the countries in question -- not with the Fed. If the Fed were to raise rates just to make others happy, it would destroy the US's meager recovery, which would hurt everyone else, too. It just makes no sense.

Since inflation and hot money in the developing world are not the Fed's problem and can be addressed by developing world central banks, it stands to reason that the "fault" lies with them, not the Fed. Case closed.

How about the dollar devaluation Europeans are moaning about? Far from "pushing its problems on others," the Fed is now actually moving America out of a position where it buys everyone else's stuff on credit (essentially subsidizing everyone else's economies while plunging itself foolishly into debt). The US dollar is overvalued, judging by America's current account (essentially trade) deficit with the rest of the world. America's consumers are broke. They can't keep buying everyone else's stuff anymore. Sorry. You'll have to look for customers elsewhere, perhaps in your own country (Germany and China!). A devaluation of the dollar would be part of the global process of rebalancing that needs to happen for the world economy to be on a stronger footing. America needs to consume less; and save, invest, and export more. Places like Germany and China need to do the opposite. Germany can't go on repressing spending and wages within its borders to sell more and buy less outside its borders. The Fed is (actually inadvertently) taking a step in that direction.

Have monetary problems? Then implement policies to address them and stop whining about the Fed. Unless you're whining about overly lax regulation and the Fed's tendency to inflate bubbles repeatedly. Those are legitimate criticisms (and the latter is admittedly related to loose policy). We can discuss those another day (and I have in the past as well, the posts are still on this site). For now, suffice it to say that the Fed's policy, while not without risks for America itself, is necessary and the only real option. What's more, other countries are not powerless in the face of any possible risks and have the ability to protect themselves, if this is even really necessary. They should implement sensible policies themselves. The world is changing. Get over it and start changing with it.


  1. Also, what I should have mentioned: It is not possible to manipulate a country's currency via interest rates or even quantitative easing alone. If the exchange rate really were to fall and give the US an advantage, this would eventually cause inflation, raising the real exchange rate back up. Interest rates are not a mechanism for influencing real exchange rates over the long term. True, lower interest rates might reduce capital inflows, but the US has a large capital account surplus. As mentioned, it borrows and spend too much. Reduced capital inflows would be welcome. They would also devalue the dollar, which would lead to reduce imports and increased exports.

    However, interest rates in America cannot go any lower, and the capital account is still in surplus. The Fed, therefore, cannot alter the dollar exchange rate unilaterally. Instead, it focuses on growth and price stability at home, letting the exchange rate manage itself. Other policies, like measures to restrict credit growth, might work to reduce inflows more. Such policies, over the medium to long term, would also be helpful in rebalancing. Surplus countries like Germany will have to adjust, too. They will not longer simply be able to lend deficit countries money so that those countries buy German goods. The sooner Germans understand that their boom is in no small part due to unsustainable deficits in other countries (including within the Euro Area), the better.


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