Monday, July 7, 2008

Tough days for Ben Bernanke and the World's Central Bankers

Let me see if I got this right. I’ve been trying to think about the difficulties the world’s Central Bankers might be having now with this global chaos we are seeing. In particular, I want to see if I can understand the factors that might be bedevilling US Fed Chairman Ben Bernanke.

To increase rates or to lower rates? Inflation or stagflation? Higher unemployment or higher prices? Overheating economy or disappearing credit?

Just what the heck is the real earth-shattering problem of the world?

Let’s start with Bernanke. The US economy is currently soft. With the sub-prime blowout and the resulting deleveraging, its economy is faltering. Ideally, rates should fall.

But then, there’s also rising inflation world-wide. Commodity prices are soaring, leading to increasing costs of doing business. If prices continue to rise, real interest rates will continue to decline, making it less favourable for people to save money. If people use money to pay for goods now instead of save, it can damage the economy. Hence, rates should be increased to tame inflation.

The rest of the world does not have the sub-prime problem. Well, they got it a bit in Europe, but they don’t have that problem in Asia. Hence, without the soft economy problem, everybody’s going gang-busters with growth. And that’s contributing to the continuing commodity inflation. Hence, in the rest of the world, the balance is tipped more in the favour of increasing rates. Still with me?

But what happens then, if you’re US Fed Chairman Bernanke, and the rest of the world is increasing rates to tame inflation, while you stay put or even lower your own rates?

Your currency goes down when compared to other currencies. Much lower it goes as more investors go to the stronger currencies with the stronger economies and the more favourable rates. What happens then to the US economy?

With a depreciating dollar, inflation becomes more of a problem for Americans, as imported commodities become more expensive. Which only further exacerbates their already soft economy.

But with other countries having no other choice but to raise rates, both to contain inflation in their own economies, and also, in effect, to contain inflation worldwide, their currencies become stronger. With that, their stronger currency enables their economies to nullify the effects of the higher interest rates. Hence, many credit-worthy businesses continue to invest, leading to more inflation.

With more global inflation and a still falling dollar, the US economy gets even weaker. What's a Central Banker to do?


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