Excerpt from John Makin's latest commentary:

There is a connection between the necessary, rapid easing of monetary policy by the Federal Reserve and the sharp increase in global food and energy prices that is feeding back onto the United States as a contractionary force by reducing real purchasing power. The currency pegs to the dollar of some large, rapidly growing countries, including China, Russia, and Brazil, in effect make the Federal Reserve the central bank of those countries. Steep cuts in interest rates by the Federal Reserve to help cushion the impact of the bursting of the housing bubble have created a huge inflow of funds in search of returns to these same emerging market countries, as well as India and Middle Eastern oil exporters. The attempt to peg their currencies to the dollar forces those countries to produce rapid increases in liquidity that, in turn, stimulate demand growth for food and energy products. So by pegging their currencies to the dollar, those countries are forcing more adjustment in the United States to higher energy prices. The more the Fed eases to accommodate credit strains in the U.S. economy, the more money floods abroad into emerging market countries and pushes up their energy prices. Beyond that, energy prices are held below market levels by governments such as that of China so that as their economies grow more rapidly, the demand for energy expands even faster without any discipline from higher prices, and so inflation in other sectors rises. The estimated effective oil price inside China is about $60 a barrel--half the full international market price. Rapidly rising inflation and accommodating central banks have resulted in negative real interest rates in most emerging countries--a further spur to more inflation. The corollary is that energy prices have to rise more in the United States in order to slow the global growth of demand for food and energy products.

Higher food and energy prices feed back negatively onto U.S. and developed economies in two ways. The higher inflation hurts the terms of trade of the developed countries and compresses real wages and profits. U.S. real wage growth has already dropped below zero, while profit compression is becoming more intense as U.S. companies, facing higher input costs, are unable to pass on the higher costs through price increases in a slowing U.S. economy.

The second negative impact of the stimulative policies to ease the credit crisis arises from the commitment of central banks in developed countries to resist infla-tion pressure. The Fed, after its April 30 reduction ofthe federal funds rate to 2 percent, with two dissenting votes in the Open Market Committee against that rate cut, has already signaled a desire to stop easing in the face of higher inflation pressures from higher food and energy prices. The determination of the European Central Bank, the Bank of England, and the Bank of Japan to resist higher energy prices has also been clearly stated.