Deflation, Fed Policy and Exchange Rates

The big story has been Ben Bernanke going to bat for Fed policy against both domestic and international critics over QE2. Domestically, the big fear is inflation. But the new inflation numbers (core CPI) show that inflation is at historic lows and going lower. The fear is that the United States is following Japan in into its own lost decade. The chart below from the New York Times shows this clearly.




























China has made it clear that it opposes QE2 because it will lower the value of the dollar, which will make it harder for China to maintain its huge trade surplus. In response to QE2, the Chinese Central Bank has raised its reserve requirements by half a percent (the Chinese Central Bank uses the reserves to buy dollars) which will negate the affect of QE2 plan. This is described in a good article in the New York Times. Here is an example of banking policy affecting exchange rates.

Deflation: Then & Now

The Economix blog at the New York Times posted a chart and explanation comparing the rate of deflation now to 1929, at the start of the Great Depression. The chart is shown below:

There are two points to note on the chart. First, it clearly shows the deflationary effects of the credit crisis - the rate of deflation was worse than that of the early Great Depression (that deflationary period set off a vicious cycle that led to later deflation). The second point is how, in the longer run, the more recent deflation problem has been relatively small - until recently. The big question is whether this recent downturn (last three months) will continue. The high level of unemployment and low consumer confidence are not encouraging.

From the perspective of teaching, I really like the chart above because of the comparison it sets up. My students are seniors, so they have had U.S. History and know about the Depression. A chart that sets up a comparison is good because it gets the students thinking about what might be different this time. While lots of things are different, the biggest difference is policy. The halt of deflation in the months after the credit crisis was the result of very active monetary and fiscal policy. The point of the chart it that it demonstrated that these policies worked - in the sense that they put off economic collapse.

A good question to ask students is how to use the information in the chart to forecast where the economy is going and what, if any, policy should be enacted. In other words, should the Fed be more aggressive in an easy money policy and should there be more fiscal stimulus, since both policies would be inflationary (or at least anti-deflationary). Getting students in the practice of forecasting and thinking about policy is getting them to do what economists do.