Dollars and Jens
Saturday, April 10, 2004
external price shocks
The first charge of monetary policy is to maintain a stable currency, because an economy without a medium of exchange is a barter economy of ditch-dwelling heathens. As a currency begins a slide into devaluation, other issues — full employment, I'm talking to you — have to take a back seat in the short term, largely because 1) there are other levers that can deal with that as effectively as the monitary, and none that can save the currency, and 2) in the long term, having defended the currency will prove to be much, much more valuable than allowing it to deteriorate to stave off economic collapse by a few more weeks. Money is the oil in the machinery of capitalism.
When light sweet crude costs more of the green stuff, though, the fed has to decide the appropriate response. Creating more or less money does little (especially in theory) to affect relative prices; that oil becomes more expensive relative to baking powder is a fact to be accepted by the Fed. Unless something has caused a demand shock from inside the United States, the higher price represents to the United States a shortage of supply, whether due to an actual slowdown in production or a demand spike somewhere else; I heard a fellow on the radio this weekend argue that the fed will not react to the recent expense of oil, because "they know they can't print oil".
I have a lot of respect for that position, the rest of this post notwithstanding, but a given amount of money chasing fewer goods is quite as capable of cheapening as is an increasing amount of money chasing a constant quantity of goods. A decreasing quantity of goods may decrease the velocity at which the money in circulation moves, but unless that effect outstrips the diminishing ratio of goods to money — and I don't believe that, in the long term, it can — the issue is not why the currency fails to hold its value, merely that it does; if the fed declines to tighten in response to higher oil prices, it isn't because higher oil prices should never trigger a response, but because the increase is really not as economically significant as portrayed in the press, and other considerations outweigh it.
When I refer to depreciation, devaluation, stability etc., I have meant against goods that are typically purchased by Americans; I mean against foreign currencies only insofar as Americans are in the habit of purchasing foreign currencies (which is to say somewhat more than none whatsoever). Fed policy toward the exchange rate should primarily be to take it into account when assessing the likelihood of future inflation or deflation. They will have an impact on this, to the extent that we engage in international trade, and to exactly that extent should be material to the determination of fed policy. So if the falling dollar raises the price of oil in dollar terms, and this is likely to trigger a general loss of faith by sellers in the dollars they're expected to accept in exchange for their goods. That is currently not a large, obvious threat, and the fed will have other things to worry about that will at least temper interest rate hikes.