from our British friends over at the Financial Times.

The Federal Reserve needs to bear in mind that keeping the dollar as the reserve currency implies acting as the default world central banker. The Fed has not been acting very responsible lately.

Fed cannot ignore global inflation

Published: June 25 2008 19:43 | Last updated: June 25 2008 19:43

If there were a Central Bank of the World its monetary policy committee would glance at today’s inflation rates and expectations of future inflation and then raise interest rates. There is no such bank, but there is something close: the US Federal Reserve, the monetary policy of which is mirrored by many countries in the Middle East and Asia. The Fed may not want that responsibility, but it would be wise to worry because, like it or not, low Fed interest rates are contributing to global inflation.

The Fed sets interest rates for Asian countries because, explicitly or not, they manage their exchange rates against the dollar. If US interest rates are low, countries targeting the dollar are obliged to follow, because otherwise investors will sell dollars to buy their currency.

The result is that Asian countries have been notably slow to tighten monetary policy in response to the rapid rise in commodity prices. To take three examples: headline inflation in Indonesia is now 10.4 per cent, while interest rates remain at 8.5 per cent; inflation of 9.6 per cent in the Philippines is more than 4 percentage points above base rates; and while inflation in India has reached 11 per cent, policy rates have only just risen to 8.5 per cent.

All three are developing countries, and one reason inflation is so high is that food and fuel make up a greater part of the consumption of poorer people. Central bankers in most such countries also confidently predict that inflation will fall back later this year once oil price rises have fed through. That makes the dangerously sanguine assumption, however, that demands for pay rises to compensate workers for their higher cost of living will not result in a second inflation spike.

The developing world’s failure to rein in demand, largely because of its continued will to target the dollar, is contributing to inflationary pressure around the world. It is one reason the European Central Bank is forced to consider raising rates. It is also a reason for every central bank – including the Fed – to be concerned that, rather than an isolated spike in commodity prices, we are at the start of a sustained inflation.

The Fed has another reason to worry as well. The greater the inflationary pressure, and the more Asian countries are forced to raise interest rates, the greater the risk that they dump their pegs to the dollar. The results for the US would be unpleasant: a currency crash and even higher domestic inflation. The US benefits from the dollar’s use as a reserve currency; the price is that the Fed cannot forget the effects of its policy on the wider world.

Why wouldn't everyone want to continue the status quo? It's easy and safe, and the wisdom would go that it has provided unheralded wealth for many, and with just a few changes it's structural problems would be brought under control. The only problem is that those structural issues are what has permitted the explosion of wealth, but just because a lot of people have made a lot of money doesn't mean the system is sustainable. The dollar as reserve currency has permitted easy capital for the U.S. and cheaper goods by the willingness of exptorting countries to the U.S. being willing to horde dollars, instead of expecting an exchange of goods/services of equivalent value. Countries exporting to the U.S. have enjoyed the ability to develop their fledgling economies. Simple enough. But now that the U.S. finds itself in the position to act as the global central bank it must strangle it's own economy to save the global economy? The system has become dependent upon U.S. monetray policy to maintain the value of the dollar, the global economy is placing it's bets, via the hording of currency, on the health of the economy of one nation. The U.S. has placed it's economic health on the idea that the global economy will continue to want dollars.

Economists like to say things like running a current account deficit of 5% of GDP is unsustainable. But the system that we currently live under has profited from this and requires it to continue and at the same time requires the dollar to maintain strength. That is unsustainable.

I am sure many would like to point out that the greatest point in our recent economic history occured when the federal government balanced it's books. So the current model would still be workable, even better, without it's use of international debt. I would maintain, as I have said in the past, that the economic vitality of the Clinton era was due more to the IT revolution and associated economic activity than it was to the federal government balancing it's books.

An interesting aside to this is the idea of the handling of differing currencies to maintain economic growth and hold down the cost of commodities. There will be no international consensus for this. And so we wind up with a war for commodities and growth, a war fought not with arms, but fought with the policy of differing central banks. The only problem being that the very act of fighting for access to commodities and maintaining growth also maintains levels of demand. Ultimately it becomes a contest of who is willing to stomach the highest level of inflation to maintain real growth. A disasterous race.

You have a very active mind, you think in abstractions, and I often have trouble keeping up with your replies. I think you're mostly agreeing, but then you mention that the Clinton era of balanced budgets was great because of IT--and the associated activity. I was just talking straight economics, though I realize that business activity contributes to economics. I think Clinton was both lucky and had some smart people. To me, the fact that the prosperity was more evenly distributed made the late 90s so unlike the late 20s or the 1980s. It really harkened back to the 1960s in many ways. The tech mania actually was somewhat of a drawback insofar as it was euphoric, and clearly augured a market top.

I should probably spend more of that activety in this poor little head composing coherent posts.

To try to whittle it down. The way I see it too many people have benefited from the trade imbalance the U.S. carries to want to see it end. This makes it impossible for the U.S. to act as the global central bank, as the piece says it should. Certainly the Fed can act to strengthen the dollar, and cool inflation now but it is only a temporary reprieve. It comes down to simple supply and demand. The world has shown a willingness to collect lots and lots of dollar based securities, and will continue to do so, but accumulating a swamp of dollars and having them maintain value is an oxymoron, they aren't compatable ends. The longer foriegn currencies are manipulated to mainatin advantageous trade with the U.S., and the longer the dollar is artificially kept strong to keep capital inflows the worse the adjustment that needs to happen will be. What is the real value of the dollar without these supports? Lower than it is now.

Rather than making the dollar strong to make oil cheaper, oil should be valued in something other than dollars. That is the root of the problem. Inflation is harmfully accelerating on a handful of things. I wont enter into the reasonableness of inflation numbers here. We are talking about the runaway out-of control inflation represented by oil, not the undereported high but not out of control inflation like we see for many other consumer goods. So the reasons that runaway inflation exists on those few items should be addressed, it isn't broad based inflation, (heck many of the discussions here talk about the looming deflationary pressures), so in any rate shouldn't be treated like broad based inflation. The U.S. shouldn't be in a position of having to position it's monetary policy to control global inflation irregardless of the effects on it's domestic economy, which is very weak and could just weaken further if the Fed moves as aggresively as it must to contain the cost of oil. And if the U.S. economy weakens further, and further, is that going to strengthen the dollar? Is that going to increase the appearance that the U.S. can honor it's debts? I don't think so.

There must be other tools available to control the cost of oil, such as valuing it in another currency, tools other than manipulating the dollar to the ends it would have to be to accomplish that need. This whole scenario is setting up conflicting forces whithin the global economy, in terms of various currency valuations and the economic performance of differing nations that will be very hard to manage.

O.k. so I got carried away a bit again, and that is even while leaving out much of the obtuse fluff of the first post. But I hope this made my sentiments a bit clearer. Thanks for taking the time to read these though, and I'll try to keep the whole stream of conscinous thing to a minimum.

Gingham: "oil should be valued in something other than dollars."

LeRoy: Well, that is really your key recommendation. [Wouldn't you agree?]

I am wondering if you realize that that really means the end of the U.S. dollar as the major international reserve currency, inasmuch as oil remains the most fundamental commodity in the world economy. If our dollar is too unstable to price oil in, then it must not be much good for anything. Maybe the United States should abandon the dollar. Seriously. Maybe we should fire the entire Federal Reserve Board of Governors, and start all over again with a brand-new currency. [That is the only way to successfully end a hyper-inflation; and I am not saying that we are in a hyper-inflation, but Zimbabwe is going to eventually need a completely new currency.]

And, if we are at the end of the dollar as the major international reserve currency, then we are also at the end of the Pax Americana, with America being the dominant geopolitical power. These things tend to go together...as they did during the Pax Britannica, when the British pound was the world's major currency.

Just so you understand where you're heading.

You should also be aware that periods of history that saw a switch from one dominant international currency to another tended to be very traumatic periods of history. The switch from the pound to the dollar came during the interwar period of the 1920s. It came at roughly the midpoint of what I (and some other historians) call 'The Years of Crisis', from 1914 to 1945.

I think we are headed down a dangerous road, if you are calling for the world to abandon the U.S. dollar.

But that may be inevitable, given our current policies, and given the metastasizing weaknesses of the U.S. economy.

and thanks for replying; you almost always have something to say, whether it is straightforward or Stream of Consciousness.

I also agree with your point that by raising rates too much or too fast, the Fed would weaken the economy, thus setting the dollar up for a bigger fall down the road.

There is also the danger I alluded to in the post with you, LeRoy, and Phil, where the Fed allows inflation out of the bag, and then subsequently needs to tighten hard--thus, also weakening the economy down the road. Look at the 10-year T-bond yield right now. It is about 4.25%. It was about a point lower three months ago. A dovish Fed will no doubt incur higher T-bond yields, and hence, higher fixed rate mortgage costs--thus, hitting housing when it's already flat on its back. The Fed needs to be quite careful here, and keep an eye on inflationary pressures. That's partly what the FT article was about. An inactive or dovish Fed might cause other central banks to de-link their currencies from the dollar, and in fact there is the danger of a run on the dollar right now. Last year the exchange-weighted value of the dollar dipped below 80, and many people thought that, as in 1992, the sojourn below 80 would be temporary. The 80 level had acted as support for over 30 years. Instead, the dollar dropped all the way to 71, abetted by Bernanke's rate cuts, and has since risen back to 74 since March. It is now 73. The rally in the dollar only lasted a couple months, and was quite weak (< 5%). Many people are getting the idea that the dollar is permanently entering a lower plateau which will last for decades, and abandoning the notion that the dollar will recover into the 80s or 90s. A chronically weak dollar increases inflation in our trading partners who have linked to the dollar, and increases the chance that they will de-couple from the dollar.

My bottom line is that the chief responsibility of a central bank is to maintain the value of its fiat currency, and not to ensure that the economy is running at full steam--or even to bail out certain sectors, except occasionally in emergencies. We seem to be in a 'Long Emergency' not only for energy, but for finance. The politicians and the people screwed up, and we cannot inflate our way out of the jam.

I think one of the things that is happening right now is that the Greensspan era is truly over. Despite the well deserved beatings Greenspan took during his tenure there was the impression of a steady hand on the wheel. All of those incremental rate changes gave the impression of someone gently guiding the economy. Now, of course, when the subprime mess hit the fan the Fed was bailing water and filling holes but by slashing rates the way it did it set up expectations of a reactive rather than a guiding policy. So now that inflation is on fire people expect another dramatic move. This reactive/dramatic mentality isn't a good thing to be in, and may in and of itself help feed further volatility.