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What's the Trigger That Will Cause the Fed to Act?

March 17, 2013 in Economics

By Henry G. Manne, Richard W. Rahn

Henry G. Manne and Richard W. Rahn

Perhaps the most troublesome question that investors and business decision makers confront today is “When will significant inflation and interest rate increases show up?” The next quarter, the next year, the next decade? Everyone fears these, but no one can predict exactly when they will appear. Investment is severely hampered by this uncertainty. The potential inflationary/interest rate pressures exist largely as a result of Fed’s massive purchase of government bonds and mortgage-backed securities. But much of this increase in money is locked up in the banks because the Fed now pays interest on the bank reserves held at the Fed (and therefore it is not lent or spent), because of increased regulatory restrictions that discourage banks from making loans to small businesses and consumers, and because of the lack of demand for new loans. In addition, many individuals and businesses are holding unusually high sums to weather regulatory and economic uncertainties.

Yet, there are many factors that could trigger inflationary/interest rate increases that are largely out of the Fed’s ability to forecast and control. After all, the Fed consistently underestimated the inflation of the 1970s, failed to anticipate the recessions in 1990 and 2001, which it induced, and was surprised by the Great Recession, in part caused by the Fed’s providing the monetary fuel for the housing bubble. For each of the last four years, the Fed (and the administration) has been telling us to expect four percent growth in the next year when the actual number has been approximately two percent. There is always economic uncertainty; but given the unprecedented debt-to-GDP levels in most of the world’s major nations, almost any sizeable disrupter could set off a very steep rise in inflation and/or a great economic contraction.

While inflation may fundamentally result from too great a creation of money, the proximate or immediate cause of its actual development is much more a function of expectations of what will happen next. This, the Fed cannot hope to control. Rarely does inflation develop gradually, monotonically or predictably; much more likely, at least in a context like the present, it is some sort of triggering event that detonates the explosive mix that already exists. Inflationary/interest rate expectations can change overnight, which will cause a sharp spike in the velocity of money (which has been declining for the past six years to record lows), as those who are sitting on idle …read more
Source: OP-EDS

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