Inflation Echoes From Abroad

By Steven Pearlstein
Wednesday, December 12, 2007

The Federal Reserve disappointed Wall Street yesterday 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 little the Fed can do about inflation right now. That's because the sources of inflationary pressures are global rather than national, 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. Over the years, a number of countries have learned this lesson -- painfully -- as they found themselves unable to tame inflation, respond to a recession or stop a run on their currencies.

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 also countries in Central and South America that are careful not to let their currencies wander too far from that of their largest trading partner. 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. In the process, the Fed's influence over credit creation and interest rates was diminished.

Back home, meanwhile, the steps taken by countries to keep their currencies from appreciating against the dollar have 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, effectively expanding the local money supply more than was healthy. 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, driving up world commodity prices to record levels.

Countries with undervalued currencies and good growth rates were also magnets for foreign investment. As a result, multinational corporations and global investors have poured hundreds of billions of dollars into these countries, financing new companies, expanding existing ones and fueling a building boom. The effect has been to turn fast-growing economies into overheated ones, in the process creating real estate and stock market bubbles from Rio to Shanghai.

So far, 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 falling dollar, along with higher prices for oil, food and other commodities, are the big drivers of U.S. inflation. But it's also worth noting that prices for imported finished goods are also on the rise, even from countries whose currencies are pegged to the dollar. In October, the Commerce Department reported that the price of all imports, including fuel, was up 9.6 percent from a year earlier, while the inflation rate excluding the cost of fuel was still a healthy 2.4 percent. Even imports from China were more expensive, up 2.2 percent -- hardly the disinflationary force they were only a few years ago.

This is one reason the Fed is now in a box. Because of these global factors, the country faces the very real prospect of several years of uncomfortably high inflation and unpleasantly slow growth-- two conditions which, in a closed economy, do not normally coexist. And given the blunt tools at the Fed's disposal, doing something about the one probably means making things worse for the other. Such is the policy conundrum of stagflation.

Given the global nature of today's inflation, however, there is probably little the Fed can do about it in the short run. So 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. The resulting slowdown in economic growth should bring better balance to the trade accounts, let the air out of the remaining asset bubbles and ease inflation pressures abroad and at home.

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.

Steven Pearlstein will host a Web discussion today at 11 a.m. at washingtonpost. com. He can be reached

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