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Letter to the editor

Why inflation is out of the Fed's hands

By STEVEN PEARLSTEIN, Washington Post
Published December 14, 2007

The Federal Reserve disappointed Wall Street this week with its measly quarter-point reduction in interest rates. Yes, the Fed said, credit conditions have deteriorated and a recession is possible, but with consumer prices likely to end the year up nearly 4 percent, we're not exactly in the target zone for price stability, either.

As it happens, there's probably very little the Fed can do about inflation right now. That's because the sources of inflationary pressures are global, and thus not very responsive to the Fed's anti-inflation medicine. To understand how this happened, stay with me for a short, explanatory detour into international economics.

It's always been said that when another country ties its currency to the U.S. dollar, it is effectively giving up the right to control its own monetary policy and handing it to the Fed. What we are discovering, however, is that if enough countries go this route and adopt some form of dollar peg, it's not only the other countries that lose control of monetary policy - to a degree, it's the United States as well.

As you probably have figured out, the big culprit here is China, whose insistence on preventing its currency from appreciating against the dollar has created huge imbalances in the global economy. But it's not just China. A number of other of Asia's export tigers also use various mechanisms to keep their currencies roughly pegged to the dollar, as have many Middle Eastern countries whose economies are tied to oil that is priced in dollars. There are countries in Central and South America that are careful not to let their currencies wander too far. Add it all up and you're talking about more than 40 percent of the global economy that is dollar-pegged to some degree.

All this might work just fine if the trade between these countries were roughly in balance. But in recent years, those trade flows have been massively imbalanced, in part because of these dollar pegs. Therein lies the problem.

Generally speaking, the way those countries have kept their pegs has been to invest the dollars they earned from a trade surplus back into the United States rather than exchanging them for their own currency. And that recycling of trade surpluses had the effect of making a lot of cheap credit available in the United States. The credit was not only used by investors to bid up the price of stocks, exotic securities and real estate, but also used by consumers to go on a buying spree for even more foreign imports.

Back home, meanwhile, the steps taken by countries to keep their currencies from appreciating against the dollar has had serious inflationary effects.

To sop up all those dollars, foreign central banks had to buy them up from local exporters using freshly printed riyal and yuan. That causes inflation.

Equally important, by using an underpriced currency to turbocharge their export machines, these countries artificially stimulated their own economic growth. Over time, that has led to higher wages and prices at home. It also increased demand for oil, metals and food.

It's all been great for global economic growth and global investment returns. But it's also become highly inflationary - all the more so since the dollar began its recent decline, increasing the cost of goods imported from any country without a dollar peg. Now, that overseas inflation is being imported into the United States.

The right strategy is the one the Fed has decided to follow - making sure that the unwinding of the credit bubble proceeds in an orderly fashion. It won't be a painless process, nor will it be over in a quarter or two. But it would all go smoother and faster if China and the others would move gradually but decisively to untether their currencies from the dollar.

[Last modified December 14, 2007, 01:23:12]