In 24 hours the Fed Chairman Ben Bernanke’s short run will begin. He will be in front of the House and Senate Committees overseeing the Fed over the next two days testifying about the health and the future of the U.S economy.
The discussion, as usual, will be about stable prices, unemployment and long term interest rates. The focus, however, would be unusual. Prices could be unstable, unemployment―long and dreary and long term rates a great cause of worry. The entire mandate of the Fed is up the in the air. What is the Fed to do? What is the rest of the government to do?
The tail risks are fat. Like that of a Chinese dragon breathing fire as if from the top of an oil well. If we play nice with the Chinese and the Muslims, they may not inflict us with the twin shocks of econometric kurtosis that could render us temporarily incapacitated, at a time of their own choosing. That time, they know and we know, is not tomorrow morning or the short run of the Fed’s 3 year forecast horizon. All the warring sides yearning for peace need the same time to make their next move. Still the tippy toeing to decide on what those moves are going to be must begin tomorrow, clearly communicated in the public domain, to minimize surprises to any side when they are least anticipated.
Stable prices are primarily about the prices of energy and food. As higher prices of energy and food, which are both set by global markets, rise, they cascade into the rest of the economy through wages and prices. 3 per cent consumer price index (CPI) inflation in 2009 could turn into 4 per cent CPI inflation in 2010 or even 5 per cent, if the global economy is not careful in how it allocates its resources. And this means, the Fed’s hands will be tied by mid-2010 (if 4 per cent inflation is expected by December 2010) or mid-2011 (if 4 per cent inflation is expected by mid-2011) to begin raising the federal funds rate from somewhere between 0 and 0.25 per cent right now. Both the possible interest rate path as well as the tolerable highest level of CPI inflation (5 per cent) are clear, barring any major negative events between now and mid-2011. Then the question becomes one of allocating resources, both domestically and globally, to structurally delay the onset of the remaining 2 percentage points of CPI inflation for as long as we can. The issue is “how?”
Supply and demand always provide magical answers because this is how equilibrium price is set ― up, down and moderate. The President is keen on committing the country, given the circumstances, despite his campaign rhetoric, to increasing domestic oil and gas production to lower prices, while pursuing renewable energy alternatives and policies to promote energy efficiency. It is possible to even ask the Organization for Petroleum Exporting Countries (OPEC) to do the same, because if the global economy declines again due to fears of stagflation in half of the world’s gross domestic product produced out of the United States and Europe, the reduction in aggregate demand as a result of that decline will lower oil and gas prices. It is not in OPEC’s interest to not raise production.
Shifting out the supply curve when demand is low for oil and gas will lower the price now and raise it as the global economy recovers, to avert inflation during recovery. The price will rise as the demand for oil and gas rises while the global economy recovers. This ought to be the lesson learned by OPEC from the 1973 Arab oil embargo before oil prices could rise again just as they did in the run up to the crisis that began in 2007.
Complementing that oil price increase was another commodity price increase: food. Not because the food producing countries of the world cannot produce more. As the Food and Agricultural Organization (FAO) has pointed out in 2007, food production should rise and become more efficient even as the food markets are developed in Africa and in the former Soviet bloc countries.
And more immediately, within the United States, U.S trade policy can and must diversify out of China and the United States must realign its relationship with a far stronger and more mature China to directly compete with it in the global markets to begin treating the China as a country that has been integrated well into the world economy.