Why Fed kept its rates unchanged and back to basics

By Chirag Shah

I read this article by Kel Kelly titled Macro Economic Theory Confusion on Inflation, Commodities, and the Fed on May 12, 2011 For full article kindly refer to the following link:http://www.marketoracle.co.uk/Article28098.html On one of the point in the above article i.e. Why the Fed is Leaving Rates Alone I have a totally different view. Heres an excerpt from the same article Why the Fed Is Leaving Rates Alone Nonetheless, Liesman explained the reasons the Fed has decided to leave rates unchanged. He first noted that the argument some put forth is that the Fed should raise interest rates in order to cool rapidly rising commodities prices that are leading to wholesale price inflation. But he then said that the Fed has stated it is not going to react to commodity prices, because those price increases are coming from economic growth in emerging markets, not from the Fed. (And, of course, the Fed is not going to publicly admit that due to its recent attempts to address the problems of its own prior actions, it can do nothing about rising prices now.) What's wrong with this argument is the idea that commodities prices or inflation can arise from strong economic growth. What the Fed is referring to regarding emerging markets growth is the Keynesian notion that after a period of strong economic growth, inflation can arise from too much demand chasing too few goods. This "too much demand" is usually said to be caused by workers/consumers via increased spending resulting from increased employment. In this way, more employment would cause inflation. This increased employment and spending that leads to prices rising faster than goods is what Keynesians call demand-pull inflation. They admit that inflation causes prices to rise though they claim that many, many other factors do as well but only when the economy is operating at full capacity. The main problem with this theory is that Keynesians claim that additional demand comes from additional production and employment instead of from the central bank. "Demand" consists of the desire plus the ability to purchase something. People can only demand and purchase something by paying for it. They pay for it by exchanging other goods that have been produced; money is simply the medium of exchange. Thus, production is the source of true demand. But when the medium of exchange money is increased, the price of the product being purchased will rise. Such a rise is not an increase in real demand; it is an increase in the prices of products being produced. Real demand can increase only by way of an increase in production, which in fact lowers prices.[2] In reality, the increased demand that the Keynesians refer to (but do not name) is increased monetary demand, not real demand. Increased monetary demand

comes only from an increase in the quantity of money pushing up prices. It is quite incorrect to argue that producing more goods will result in prices rising instead of falling. It is also incorrect to say that an economy can overheat as a consequence of (real) demand exceeding supply, since increased real demand comes from increased production, which itself results in a greater supply. An increase in demand which is in fact an increase in supply cannot cause prices to rise. Prices can rise only if the monetary unit is being devalued as more money is being added to the economy. Thus, the only thing "overheating" is the government's printing presses.

Here is what I have to say on the above

I totally disagree most of the above facts.

Taking your definition of demand i.e. desire backed by ability to purchase - My desires are never ending so are yours and of all living beings in this universe. I may desire to have a Rolls Royce but simply desire cannot create demand, right? For desire to become demand, ability is a must. How can ability to purchase increase (as per explanation above) through production how production can increase? Through increased resources But for that same resources money is required. So whole point ends in saying that ability to purchase comes from increased monetary holdings in hand. Let me give you a simple example of a Burger shop. The burger shop is able to sell every day only between 25 30 burgers a day. But he produces 40 burgers, everyday. If he increases his production of burgers my 1st question is why he should increase his production as it is not able to sell its daily production only? And 2nd question, if he intends to increase production; how he can do so?

1. How can he increase its production as there is no incentive such as demand from

consumers making him think to increase production? 2. Why he should increase its production if he is unable to sell even those 40 burgers, some of which gets wasted every day.

In order to increase production, only solution that he has is the demand should go up. Fed is trying to work on the same by trying to increase the ability of people of U.S. to purchase in order to encourage increased spending leading to increased demand.

But Fed is not succeeding in its Keynesian model application simply because the path through which money printed by it can reach to reach public is through Banks. But as you are aware, banks are hoarding excess reserves of dollars and were not encouraging lending. This is one of the reasons why value of dollar has not got eroded so much which was expected at the back of the Feds excess money printing because till now it hasnt got circulated in the market. May be the market has recovered somewhat, but for Fed; its a long way to trim the deficit that it has created by following a very risky step of money printing. But as the scenario is changing, lending is increasing somewhat, Fed does not wants to discourage it due to which it has kept rates unchanged.

HAPPY LEARNING!!!

About me: My name is Chirag Shah. I am currently working in NSDL (National Securities Depository Limited). I have completed MS (Finance) after my graduation (B.M.S. specializing in Finance). I like to read economic editorials the most. I stress on continuous learning. What makes it interesting is the different theories that may prove right in certain situations but not in all situations making analysing part more challenging and interesting (In short, its not like science which has fixed theories and laws which works in any situation which once learned, one can earn continuously thereafter). Due to this goes my philosophy Learn continuously, earn continuously.