The law of unintended consequences

Currencies, Economic growth

There’s an interesting article on Bloomberg, suggesting that the US Fed’s dramatic interest rates reductions are ‘driving Asia’s governments back to controlled economies’.

Its argument is that by cutting rates, Bernanke is ‘limiting his Asian counterparts’ ability to curb inflation’. It goes on to argue that Asian banks cannot now raise domestic interest rates to restrict demand, as a ‘widening spread between US and Asian borrowing costs draws more foreign money into the region’, causing asset bubbles to appear.

The same effect will occur if they allow their exchange rate to rise too quickly versus the dollar. And Asian central banks certainly don’t want to encourage a repeat of the US housing bubble in their own countries. So they are instead being forced to impose price controls on essential goods, in a bid to restrain inflation.

As I noted on 10 January, China froze the prices of oil products, natural gas and electricity, as well as public transportation. 5 days later, just as the Fed embarked on its 2nd round of interest rate cuts, it added price controls on grain, cooking oil, meat products, milk, eggs and LPG. The rationale can be seen in today’s announcement that inflation hit 7.1% in January, the highest for 11 years.

The problem, of course, is that domestic price controls (which also now apply in many other Asian countries for similar reasons), reduce the incentive to cut back on consumption as world prices move higher. The same is true for oil and gasoline prices, which are subsidised across Asia and also in many OPEC countries.

Thus the law of unintended consequences applies. These subsidies mean that supply and demand will be much slower to rebalance. So the net effect is that as the Fed reduces rates to try to avoid a severe US recession, it is indirectly causing global food and energy prices to rise. And in the end, if inflation starts to spiral out of control, rate increases may become essential, even in the US.

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