More on inflation

I admire Paul Kasriel's forecasting abilities. He has a recent research report (HT: Calculated Risk) where he describes a scenario where inflation can increase. He is more scared of inflation than I am. His scenario is that foreign countries will drop the dollar instead of defending their pegs ending their purchases (to defend). The current defending involves purchasing dollars by printing home country currency which leads to inflation (that will inevitably need to be reined in). Furthermore, these countries have acquired massive dollar holdings and eliminating the buying pressure could further depress the dollar and result in inflation at home.

I think these are all good points (though that were just as true in 2005 as they are now), but he misses one main point. The massive dollar holdings abroad represent significant assets on the balance sheets of central banks. If they drop the dollar, they know it will cause a drop in the value of their assets which will have a competing affect on the value of central bank reserves. I think each central bank is worried that another (major) central bank will unpeg their currency first, not that different than Mutually Assured Destruction. If inflation gets out of control in one of these countries where they have nothing else left to do, then Mr. Kasriel's scenario is a real possibility. However, I would consider this an exogenous shock to react to if it occurs and not something forecastable (unless seen a mile away in import prices or trends in inflation numbers of those countries) than I would actively bet money on.

In other words, I'm still more worried about the monetary base contracting in the U.S. and leading the recession here than I am about Mr. Kasriel's scenario.