Depends on what you mean by 'inflation'

I was drawn to this article by its headline reporting that Warren Buffett, the billionaire investor and world's richest man, does not agree with Ben Bernanke's views on inflation and its medium to long-term impact on the U.S. economy. What I'll comment about, however, is the apparent distinction that the Fed makes between relative-price changes and what we would otherwise call inflation. Did you know that they made a distinction? I didn't!

Relative changes in prices are considered to be the result of the demand and supply forces that underly any market for a good or service. Inflation, more generally, is the resulting affect of a general change in price levels that causes our purchasing power to be reduced (assuming positive inflation, of course). What's interesting about this distinction, beyond the fact that such a distinction is even made, is that the Fed (and by the Fed, I'm really referring to Mr. Bernanke) believes that relative price changes are otherwise transitory and will not necessarily lead to inflation. The argument is one that I've written on before, simply that wages are sticky upward and that will mean subdued inflationary pressure. There is a problem with this argument though...

I do agree that wages are sticky and that will mean that inflationary pressures are somewhat tethered. That said, it would be difficult for anyone to argue that purchasing power has not been affected. Beyond the cost of fuel and the rising cost of food, consumer wealth is falling rapidly and this has a very real affect on consumption. As consumer wealth falls, they have less collateral and a generally lower willingness to spend. This, of course, must necessarily result reduced demand which will then result in slower sales, layoffs, even more bankruptcies, and ultimately even slower economic growth. So, my question, then, why does the Fed make such a distinction between relative-price changes and what we plebes call inflation if they both lead to the same thing?

Competition & Deregulation Fight Stagflation Part 2

Sometimes it seems as though there's a counter-argument for every argument; isn't it great! I just finished writing how competition and deregulation was working to prevent inflationary pressures from spiraling out of control and then I read this article that made me rethink my position, again. I still believe that competition and deregulation are in-fact working to keep those pressures under control, but I neglected to consider the effects of rising fuel prices on the extent to which that competition can take place.

There's no doubt that communications technologies enable for a great deal of competition in the services sectors, but that's going to have a lot less of an impact on the manufacturing side of the economy. Ultimately, manufacturers have too get their goods into a market before they can sell them there and the rising cost of oil has made that far more expensive. The result is that domestically produced goods are just a little more attractive and the demand for those goods, as a consequence, is just a little higher. This higher demand for domestic manufacturing empowers laborers just a little more and makes wage-hikes just that much more likely. As I've written before, rising wages is the key influential factor driving inflation.

So where do the scales balance? Good question; it's anyone's guess really. I will say that the forces of competition and deregulation are not going away, but the oil price bubble may very well disappear. What happens then?

Of course it's an Oil Price Bubble!

It's almost funny how the discussion over whether oil prices are spurred by speculation or market demand forces; of course it's a speculative bubble. Those arguing against this view are quick to point to China's growing economy and similar demands from India; there's no doubt that that is the case, but it's ridiculous to think that anything changed so drastically in either of those markets within the past year to justify the rising prices we see around the world.

Need some proof, no problem. How about the total notional value of over-the-counter commodities derivatives that have risen from $1.02 trillion in 2004 to a value of approximately $8.4 trillion by the end of 2007. Yes, there no doubt that some fundamental demand must be credited for part of this rise, but numbers are simply so staggering that suggesting a speculative bubble is not the primary culprit is simply irresponsible. So, assuming that it is a speculative bubble, why is that important? Good question!

The prices are now so high that they are actually affecting demand - rather than vice versa. Drivers are driving less; airlines are cutting flights and jobs as well as authorizing new fees for customers to cover the cost of rising fuel prices. Similarly, other commodities are rising (most notably wheat prices, which have doubled in the past few months) under pressure from increased transportation costs. All these rising costs mean one thing: a slowing economy. Given that many, including the likes of Mr. Warren Buffett, have publicly stated that we are already in a recession, this does not paint a rosy picture for our economic near-future.

Yes, inflation is also a big deal. With all these rising pressures the concerns over inflation have been rising as well. The only thing that has kept those inflation rates from jumping along with commodity prices has been the Fed's ability to retain the trust of its citizenry who appear to continue to believe it has things under control; this belief has led to stable wage prices. Basically, people don't believe that it's in their interest to demand higher wages because of the rising unemployment rates. That said, this won't last. As prices continue to rise, people will eventually have to demand more money in order to pay for that expensive gasoline and bread and, when they do, the Fed will lose control. Fed Chairman Ben Bernanke has received a lot of kudos for his efforts thus far, but if inflation isn't brought under control many believe that he will be faced with an economy similar to that faced by his predecessor Volker.

When inflation grew to double-digit-levels in the late 70s and early 80s, Fed Chairman Volker was forced to move interest rates even higher; this, of course, led to one of the deepest recessions since the great depression. Many now believe that we may be heading into a similar situation if the Fed doesn't begin to raise rates sooner rather than later. The Fed is enjoying low inflation expectations, but those expectations are beginning to show signs of upward movement and the Fed really does need to take this seriously. 

Trusting the markets to manage themselves is wise, in theory, but the market won't keep itself out of a recession. The business cycle is a natural phenomenon and the only way to flatten that cycle is via fiscal and monetary policy. If the Fed doesn't do its job, the speculative bubble will lead to one of the worst economic slowdowns ever. Ask anyone who was invested in the markets during the bubble-burst of 2000 and you're likely to hear about their lessons learned. Well, this is another bubble; it's time to apply those lessons-learned and react proactively rather than reactively.

Never mind a cut to 2%, how about a hike to 2.50%

On Wednesday this week, the Federal Reserve, headed by Ben Bernanke, will meet to decide the fate of interest rates for the next six weeks. The rate currently sits at 2.25% - 3% lower than it was just nine-months ago. Mr. Bernanke and the Fed have been very aggressive with their cuts to help keep the economy out of a recession. Today, however, with most people agreeing that the economy is already in a recession, what should the Fed do next? More importantly, with inflation concerns higher than ever, a further attempt by the Fed to keep this recession as mild as possible could come at an incredible cost a year from now.

The rising cost of fuel and, more recently, commodity prices have made living expenses rise for the average consumer. The Fed hasn't helped either. The lower interest rates have caused the American dollar to sink against the Euro and other currencies - as much as 7%! This too has caused import prices more expensive and driven-up costs for consumers. All these rising prices mean one thing: inflationary pressures.

Today's economy is being compared to that of the late 70s and early 80s more than ever. A lot of people are beginning to foresee high inflation. The only thing that has helped the Fed, and the economy, is the general believe by the American people that the Fed is doing (and will continue to do) all that it can to keep inflation under control. This belief may quickly vanish, however, if the Fed doesn't begin to deliver on those expectations. Why care?

If inflation does start to creep-up like a lot of people believe that it will, then it will need to eventually be brought under control by the Federal Reserve. In the 80s, Paul Volcker, then Fed Chairman, pushed interest rates up to the high-teens in order to bring inflation back from its double-digit levels. This, of course, sent the economy into a VERY deep recession. If Mr. Bernanke isn't careful, his successor will need to do the same thing because he'll certainly be out of a job.

As speculation mounts over whether the Fed's meeting will result in a quarter percentage point cut to 2% or stay-the-course at 2.25%, maybe the Fed should rather be considering a quarter-point hike!

Is there really a difference between 2.25% and 2.00%

Ok, so I studied finance and I know that there is a 25-basis-point difference, but I think that you and I both know that that's not what I meant.

The Fed (the U.S. Federal Reserve Bank), via the open market operations, helps to manage the swings in the business cycle by monitoring various economic indicators and pulling various levers to flatten-out the bumps. One of these levers, the most important one actually, is the interest rate (the Fed Funds Rate, to be precise).

When the Fed reduces the interest rate, it makes money cheaper - it makes borrowing money less expensive because those who do borrow, pay less interest. You have to ask yourself, however, whether a 0.25% further reduction in the interest rate will stimulate those who have been holding-off on an investment decision (like buying a home or expanding business operations) to suddenly make the leap. The answer is likely no.

The Fed's actions are likely less important that the reasons for its actions. People watch the Fed to learn of what top economic minds think the economy will do next (or what it's doing now). With almost 300-basis-points down in the last 9-months, I think that we all can accept that the Fed and all those economic brains think that the economy needs help. We got the message, trust me. Sending the rate lower yet will not drive-home that message any further; moreover, it could cause problems for the Fed in the medium term should it really need to pull on that lever harder, later. It's going to be interesting to see what the Fed chooses to do; it will be more interesting to see if the markets react at all to whatever it is that they do choose to do!