Fed's "QE2" Could Fuel Inflation in U.S. & Deflation in Europe

The U. S. Federal Reserve's latest round of quantitative easing (QE2) may further escalate the currency war
by producing a crippling bout of deflation in Europe and conversely, another period of inflation on the domestic front.

The diverse results are possible because further Fed purchases of debt are likely to re-ignite economic growth and increase prices in the United States, while a surging Euro will make it more difficult for European countries to pay off debt.

Fed purchases of Treasuries to stimulate the U.S. economy could send the euro rising against the dollar, sparking deflation in Europe, Nobel Prize-winning economist Robert Mundell told Bloomberg News.

The Fed announced yesterday (Wednesday) that it would buy an additional $600 billion of U.S. Treasuries to spur the economy.

As the U.S further debases the dollar with another round of stimulus, the European Central Bank (ECB) would be unlikely to stem the euro's gains, Mundell told Bloomberg in an interview in Beijing. In an earlier speech, he said U.S. quantitative easing would hurt nations around the world.

The ECB's mandate to control inflation would likely hamper it from stemming the euro's rise, while the currency's gains would "likely lead to deflation," Mundell said. Falling prices would increase "the real value of indebtedness."

Deflation would worsen European sovereign credit woes by making debts harder to pay off, said Mundell, who won a Nobel Prize in economics in 1999 and is credited as the intellectual father of the euro.

European governments imposed austerity measures after Greece nearly defaulted on its debt last spring. The European Union was forced to assemble a $1 trillion rescue package, and members Ireland, Portugal and Spain were clobbered by series of debt rating downgrades.

By launching another round of quantitative easing, the United States is "terrorizing" the world economy, Mundell said in an earlier speech at a forum run by Bank of America- Merrill Lynch.  He compared a quantitative easing-induced dollar devaluation to an "inflation tax" of the 1970s.

"Dollars were depreciating in value, dollars were the major reserve, this was a tax on dollars held outside" the United States, Mundell said.

Mundell's warning highlights how U.S. monetary policy may have potential unintended consequences. Brazil said last month that the global economy is suffering from a "currency war" as countries devalue their currencies in a "race to the bottom" in an effort to increase exports.

Others fear that by pumping more liquidity into the world's largest economy, the Fed may be risking a return to inflation for the second time in less than a decade by venturing down the same policy path they followed in 2003-04

Earlier this decade the Fed kept borrowing costs at near record lows as inflation rose faster than anticipated.

U.S. Federal Reserve Chairman Ben S. Bernanke risks increasing expectations for higher inflation by too much, causing a shake- up in currency and bond markets, James D. Hamilton, a University of California, San Diego economist told Bloomberg.

"That perception alone would bring about a series of immediate challenges, such as a rapid flight from the dollar, commodity speculation and possible under-subscription to Treasury auctions," said Hamilton, a former visiting scholar at the Fed board and the New York and Atlanta district banks. "So the Fed has a careful tightrope act here."

The newest round of easing would probably cause inflation excluding food and energy to exceed 2% by 2012, above the Fed's preferred gauge, according to seven economists surveyed by Bloomberg.

"The parallels are very close to 2003, when the Fed had a maximum degree of panic about deflation when inflation had already bottomed out and was about to pick up," said Stephen Stanley, chief economist at Pierpont Securities LLC in Stamford, Connecticut.

"Their inflation forecasts are going to be too low, and as a result policy is going to be very easy," said Stanley, a former Richmond Fed researcher who expects 2.8% inflation in 2012.

As part of its announcement yesterday, the central bank released a statement in which policymakers reiterated the view that "inflation is likely to remain subdued for some time."

The Treasury market is pricing in lower inflation expectations than it should, said Michael Pond of Barclays PLC told Bloomberg.

As a central bank governor in 2003, Bernanke pushed his peers to fight off deflation amid sluggish job growth by keeping interest rates low. The central bank kept its target rate at 1% for twelve months beginning in June 2003 to prevent prices from falling.

Meanwhile, inflation excluding food and energy rose from an initially reported 1.2% in May 2003 to above the Fed's 2% goal a year later.

The Fed has kept interest rates between 0% and 0.25% since 2008 and purchased nearly $2 trillion in government bonds in an effort to increase GDP growth and stimulate hiring.  Nevertheless, unemployment continues to hover near 10% and economic growth remains tepid after the worst recession since the 1930s.

Despite the central bank's unprecedented injections of liquidity, inflation has remained muted. The Fed's preferred price measure, which excludes food and fuel, rose 1.2% in September from a year earlier, the smallest gain since September 2001.  The Fed's long-term preferred range for inflation is roughly 1.7% - 2%.

While a cheaper dollar tends to help U.S. exports, it also risks pushing up the price of oil and other commodities, threatening an inflation surge that could be difficult to stop if the economy picks up.

Indeed, oil prices have risen 18% since May, and food staples including corn and cattle are up more than 20% this year, according to Bloomberg.

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