Where Will We Be Three Years From Now: Interest, Oil and Inflation

I told my online friend and fellow econ lover Jeff Reisberg I'd do a post about policy and the dollar exchange rates in the context of the crisis.

Should we be concerned, in light of the Fed just deciding yesterday to flood the market with more money by buying up even more long-term treasuries and mortgage securities? IE, the Fed is expanding its tool box to influence longer-term (riskier)interest rates, since it can no longer focus on the short-term rates it directly controls as interest rates on those securities are now at the 0 bound.

The policy makes sense from a stimulating the economy standpoint. More money for lending, lower economy-wide interest rates to stimulate borrowing and spending. The lower interest rates, however, make saving less attractive. This is true for our residents and foreigners that may want to put some money in our financial markets. So, as a consequence, should the Fed continue this policy of quantitative easing (as I'm sure it will), we can expect a further decreasing of the value of the dollar (which, like other financial assets, is now less attractive). Gold is more attractive (as a semi-substitute for the dollar). Oil is also attractive as it, as a potential investment, is also a semi-substitute for dollar-backed financial assets.

This stimulus only enhances the fiscal stimulus the Obama administration is attempting. As I've discussed in the past - I'm skeptical as to monetary policy's benefit at this point given the amount of hoarding and paying down of past debts going on (as opposed to new spending).

But a greater concern is the long-term issue of inflation. Everyone knows that any demand stimulation causes some degree of inflation in the future. But my concern is not with inflation from the demand side, but I am concerned about the stagflation spiral we could be in for three or four years from now.

Consider a world where the market is flooded with money, a world where months and years of spending have stabilized output and employment but prices are rising - presumably back to normal (though potentially going beyond). Consider this world where oil demand is stabilized along with the rest of the economy, but oil becomes doubly attractive due to the incredibly depreciated dollar. In this world we trade one bad for a potential other - we fix our financially broke low demand economy only to replace it with oil prices not just going back to the rapid levels we were at before the crisis, but now to a level of growth even faster due side effects of policy.

I'm here to tell you this world is not possible, for a few reasons:

1. The Fed has said, and they certainly have the power, once stabilization occurs, they will quickly reduce the money supply back in line with normal growth - the dollar therefore should adjust back to normal accordingly.

2. The demand for the dollar will likely remain high, even DURING the stabilization course - this will mean the dollar will NOT crash - it may slowly depreciate, but it will not likely be as dramatic as some doomsdayers assume.

3. A good chunk of the Obama administrations policies and indeed the stimulus package, is to ween the US off of its oil dependency. Other countries (like China) are starting to realize that oil is not a sustainable energy source for a developed economy. So, one would think that the rate of growth in global oil demand will be markedly slower post-recovery.

So, in end, I am not at all concerned about policy impacts on the dollar or oil prices or anything else. I am more concerned about the inability of monetary policy to do what it does well in normal times - stabilize.