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links for 2008-03-02

Jim Hamilton: There Is No More Macroeconomic Balance

Jim Hamilton believes that there is no "sweet spot" right now: no set of economic policies that will both avoid significantly higher unemployment and avoid significantly higher inflation. We are thus about to be forced to choose between evils:

Econbrowser: Bernanke's tightrope act: Some analysts are saying that Fed Chair Ben Bernanke is walking a tightrope--if he does not drop interest rates quickly enough, the U.S. will be in recession, but if he goes too far, we'll see a resurgence of inflation. I am increasingly persuaded that's not an accurate description....

We've seen some quite remarkable movements in commodity markets the last two months.... Topping the group is wheat, up 46% over two months; I won't try to translate that one into an annual inflation rate because I don't want to scare you.... If it were just a few commodities moving, I wouldn't be concerned.... But we are clearly looking at an aggregate phenomenon here, and it seems unreasonable to suppose that the phenomenon has nothing to do with choices by the Fed.... Now it is true that if you look at the time profile of futures contracts on these commodities, you don't see an upward slope, a fact in which Bernanke has taken solace.... But even if there is no further increase in the price of wheat, surely it's reasonable to anticipate increases yet to come in the price of bread and Wheaties and pasta.

I think part of the basis for Bernanke's optimism on inflation must be the dourness of his outlook for real economic activity. The basic macroeconomic framework in Bernanke's textbook suggests that, for given inflation expectations, if output falls below the "full-employment" level, inflation should go down, not up.

But what exactly does the theoretical full-employment level of output correspond to in the present situation? There are fundamental problems with credit markets... from a real disruption in the basic process of financial intermediation... it may be that "full-employment GDP" would actually decline this year, and an effort to use a monetary expansion to prevent that would indeed be inflationary.

Of course, a serious problem in the market for credit is another area with which Bernanke the academic is quite familiar. But... fiddling with the level of the fed funds rate is not a particularly efficacious tool for dealing with this problem... the primary way in which monetary expansion could help alleviate the current credit problems was described by Brad DeLong with remarkable clinical coolness:

Yes, the financial system is insolvent, but it has nominal liabilities and either it or its borrowers have some real assets. Print enough money and boost the price level enough, and the insolvency problem goes away without the risks entailed by putting the government in the investment and commercial banking business.

The monetary cure for our ails... has a downside... later [we will] need an artificial recession to bring the inflation back down.... [R]ecent Fed rate cuts are buying us higher output at the moment at the cost of lower output in the future.... But I disagree that the recession Bernanke is trying to avoid would be a "small" one. The Fed chief must be worried that a recession in the present instance would precipitate major financial instability, in which case perhaps the choice between paying now and paying later argues in favor of latter....

[T]he tightrope analogy seems... misleading... it presupposes that there exists a choice for the fed funds rate that would somehow contain both the solvency and the inflation problems. In my opinion, there is no such ideal target rate.... Better for everyone to admit up front... that there is no cheap way out....