Fed Up

Fed Up -

Fed's recent series of action are very eye-catching. First, Fed cut funds rate by a quarter point, as expected, and boring as Economist put; second, Fed's secrete weapon of teaming up with four other central banks to inject $40 billion liquidity; third, Fed is on a tightrope with the this morning released CPI & PPI data. CPI rose 0.8%, more than Economist concensus estimate. PPI rose 3.2%, a 34-year highest jump. These two figures dragged all three index down more than 1% today, as they limits the room of further rate cuts. So what's next in US economy? Will the economy really slides into recession next year?

What are the goals of U.S. monetary policy?

Monetary policy has two basic goals: to promote "maximum" sustainable output and employment and to promote "stable" prices. These goals are prescribed in a 1977 amendment to the Federal Reserve Act. You can refer to this link for detailed information. http://www.frbsf.org/publications/federalreserve/monetary/goals.html

Fed is now torn between a tighening money market and upside risk of inflation. To cut or not cut, this is the question. Besides, US economy's odds of getting into recession is inching up. Merrill Lynch in its Economic Commentary on Dec 10 forecasted an average 1.4% GDP growth in 2008. Housing will keep its downward trend. Employment data will retreat. Consumer confidence index released by University of Michigan sank to 74.5. Energy price will loose up in the shor term. All these factors will bring the US economy down.

Why high inflation is bad? Fed says:

High inflation is bad because it can hinder economic growth, and for a lot of reasons. For one thing, it makes it harder to tell what a change in the price of a particular product means. For example, a firm that is offered higher prices for its products can have trouble telling how much of the price change is due to stronger demand for its products and how much reflects the economy-wide rise in prices.

Moreover, when inflation is high, it also tends to vary a lot, and that makes people uncertain about what inflation will be in the future. That uncertainty can hinder economic growth in a couple of ways—it adds an inflation risk premium to long-term interest rates, and it complicates further the planning and contracting by businesses and households that are so essential to capital formation.

That's not all. Because many aspects of the tax system are not indexed to inflation, high inflation distorts economic decisions by arbitrarily increasing or decreasing after-tax rates of return to different kinds of economic activities. In addition, it leads people to spend time and resources hedging against inflation instead of pursuing more productive activities.

Another problem is that a surprise inflation tends to redistribute wealth. For example, when loans have fixed rates, a surprise inflation redistributes wealth from lenders to borrowers, because inflation lowers the real burden of making a stream of payments whose nominal value is fixed.