Friday, June 27, 2008

Fed to World: "We Want the Exorbitant Privilege, But Not the Responsibility"

Okay, the Fed did not exactly say that, but I suspect that is how the world, particularly the dollar block, is interpreting Donald Kohn's speech this week. While much was said about globalization and the issue of decoupling in the speech, the controversial part was as follows:
Additionally, in those countries where strong commodity demands are associated with rapid growth in aggregate demand that outstrips potential supply, actions to contain inflation by restraining aggregate demand would contribute to global price stability.
As reported over at Real Time Economics, this amounts to the Fed outsourcing the global inflation fight. The Fed, whose monetary policy applies to all those countries who peg their currencies to the dollar, is unwilling to sacrifice domestic economic goals in order to stabilize global inflationary pressures. While this stance makes domestic political sense, it ignores the monetary hegemon status of the Fed and its role in creating the global inflationary pressures in the first place. It also ignores the potential damage to the dollar as a reserve currency--a development that would have domestic economic implications for the Fed. As Tim Duy notes,
[T]he US has benefited by the foreign willingness to accumulate Dollar assets; it allows the US to consume well beyond productive capacities without, until recently, inflationary consequences. If the rest of the world is implored to tighten policy and weaken the Dollar, then I suspect those positive inflation dynamics will be reversed. The Fed effectively replaces one inflation concern with another by advocating what amounts to a Dollar drop.
In short, the Fed's job is made easier because it manages the main reserve currency, but it is not willing to take on the responsibilities associated with this exorbitant privilege. This complacency could be costly for the U.S. economy.

Update: The Financial Times makes a similar case in this editorial.

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