A Flood of Liquidity

Many economists and market commentators in recent months have expressed their concern that the US Federal Reserve's policies of managing the credit crunch crisis will lead eventually to more inflation and perhaps even bigger problems to solve in the future. The Fed has intervened in the credit crisis by taking unusual steps such as making credit facilities available to investment banks and facilitating the takeover of Bear Stearns.

George Magnus, senior economic advisor at UBS, however recently argued in a Financial Times article that inflation should really be of lesser concern, but what is important now is for the Fed to provide sufficient liquidity in the market to prevent a systemic meltdown such as was seen during the depression of the 1930s.

Magnus is of the opinion that unusual events merit unusual solutions, especially where systemic risk is prevailing. Furthermore, he lists a number of reasons why the criticism against the Fed's actions is largely unfounded: First, US long-term bond rates do not discount an expectation that inflation will spiral out of control. Second, the credit crisis remains largely a US problem with up to 117 of their banks in trouble as it becomes more difficult to raise capital. The consequential sell off of assets to shore up the balance sheets of banks highlights the severity of the downturn and justifies the Fed's actions. Third, consumers will find it increasingly difficult to access credit. With a slowdown in consumer spending expected the worries about inflationary pressures will become unfounded.

Thus, while the Fed's actions may be seen by some as inappropriate one must bear in mind the severity and extent of the credit crisis and its possible ramifications. In this context one former central banker is quoted: "it is after depression and unemployment have subsided that inflation become dangerous".