The Fed Is Creating - and Exporting - Asset Price Inflation

In his essay, Jerry Jordan makes a number of important points. I want to bring attention to one insightful if not provocative statement. “At its root, monetary policy is a fiscal instrument in a fiat currency world.” It is a fiscal instrument because it works by varying the rate of inflation, and inflation is a tax. Viewed that way, monetary policy is a separate system of taxation. That was an argument made cogently by Armen A. Alchian and Reuben A. Kessel in a 1962 scholarly article on the “Effects of Inflation.” Given the recent, loose talk about the benficient effects of higher inflation, their argument is worth keeping in mind.

In a gold or other commodity standard world, central banks cannot generate inflation if they want to stay on the standard. The price level is determined globally by the operation of the commodity standard. It might be better to say there is no monetary policy on a commodity standard. Hence, there is no separate fiscal policy run by central banks.

We have low (not no) price inflation, conventionally measured. But conventional measures are misleading. They exclude asset prices, and by that measure, there are quite strong inflationary pressures. Moreover, these pressures are global. The effects of easy Fed monetary policy work there way both directly and indirectly into the asset prices in other countries. Some countries, like Hong Kong, peg their currencies to the U.S. dollar. The exchange rate of the Hong Kong dollar to the U.S. dollar is maintained within a tight band. The Fed’s creation of U.S. dollars directly impacts the supply of Hong Kong dollars. In practice, that first impacts property values and equity prices in Hong Kong.

As John Taylor and others have argued, even central banks that maintain a floating exchange rate against the U.S. dollar cannot realistically fight Fed policy. To do so would cause a crippling appreciation of the exchange rate of the local currency. Hence, the Fed is exporting global asset-price inflation.

In the meantime, the Fed is engaged in what is called financial repression. By keeping nominal interest rates very low, the Fed ensures that real (inflation-adjusted) interest rates are negative. There is a massive transfer from middle-class savers to favored investors and speculators. The benficiaries are wealthier and bceome more so in the process. They are often politically connected. It is a shocking and largely unremarked regressive income-transfer policy. Once again, it illustrates how monetary policy in a fiat currency world is ficsal policy.

In his further contribution to the discussion, Jordan correctly focuses on Fed governance and the scope for massive discetion. As he observes, there are no rules governing the actions of central banks in a fiat currency world. That greatly exaccerbates the problems discussed above.

Also from this issue

Lead Essay

  • Gerald P. O’Driscoll reviews the history of central banking. He argues decentralized banking is possible, but getting there will be difficult. Under a commodity money regime, central banks are neither necessary nor particularly dangerous, while under a fiat money regime, central banks are capable of exerting substantial influence on monetary policy. The Fed’s use of that influence has been, in O’Driscoll’s words, “unenviable.” Governments have come to depend on central banks to run deficits and spend more than they otherwise could. To do without central banking, however, we will first have to shrink the federal budget itself, and this will be no easy task.

Response Essays

  • Lawrence H. White explains that the Federal Reserve has “dramatically increased secular inflation.” Additionally, it has increased price level uncertainty, while failing either to tame the business cycle or to reduce unemployment. Instead, throughout its history, it has bowed to political pressures and expanded the money supply again and again.

  • Scott Sumner argues that monetary policy needs to respond to crises, and that commodity standards don’t meet that test. He argues that a politically independent central bank tasked with keeping a low rate of inflation will generally be able to fulfill that obligation, and that rigid monetary regimes do much greater harm when they ultimately collapse. In particular, the failures of such regimes have usually been attributed to free-market capitalism, and the result is ever-greater financial regulation.

  • Jerry L. Jordan argues that legislative restraints on monetary policy tend to fail; in this area, we just can’t trust government to watch itself. Standards intended to preserve the value of the currency have all fallen, as legislatures simply find it too convenient to siphon away value through inflation. Jordan is skeptical even of a balanced budget amendment, noting that state governments with such amendments have still come to fiscal grief. One of his most important concerns is that the public right now is dangerously apathetic about this underappreciated issue.