Tuesday, September 25, 2007

Now, Some More Economic Doom... Ready?

Over at Econombrowser, Menzie Chinn asks what would be the effects of stagflation on the value of the U.S. dollar? I wrote about stagflation earlier.

Here's the nut section:
What this quote highlights is that while there are (at least) two categories of forces pushing down the dollar's value, there's one that might possibly push the opposite direction -- namely, inflationary pressures and the consequent policy response. While this seems an unlikely fear, I found this Reuters article of today of interest:
NEW YORK, Sept 24 (Reuters) - The Treasury Inflation Protected Securities (TIPS) market is likely to show inflation expectations rising through year end, a Pacific Investment Management Co fund manager said.

Break-even spreads between the nominal 10-year Treasury note yield and the equivalent TIPS should widen to near 250 basis points by December from about 230 basis points currently, John Brynjolfsson, a managing director at PIMCO, told a Euromoney conference on inflation-linked products in New York.

Widening break-even spreads reflect investors' rising inflation expectations.
Higher inflation implies a weaker currency over time. But to the extent that the Fed responds to observed and anticipated inflation, then this implies higher policy rates in the future. Then the big question is which effect dominates in moving the dollar. In addition, higher interest rates have an impact on output and asset prices at different horizons. Hence, a surprise in inflation could prompt an increase in the policy interest rates (relative to what was anticipated), which when combined with sticky prices would lead to a higher real interest rate that appreciates the dollar instantaneously and in the short run (Note: This argument relies upon a Taylor rule interpretation of monetary policy -- the currency value implications of which are drawn out in this post).

To the extent that higher interest rates depress economic activity in the medium term, this will tend to lead to a weaker currency at the longer horizon. This means that the path of the dollar may be subject to more influences than would be obvious at first glance. And that changes in policy rates may very well have different impacts at different horizons.
Shorter Menzie Chinn: the FOMC will get to decide whether you're going to be more screwed by higher prices for imported energy and manufactured goods, or instead by a tighter job market and downward wage and benefit pressures. Guess which one they're likely to pick for you!

My money is on the latter and against the former.

No comments: