Don’t Worry – Inflation is “Contained”

Ben Bernanke makes me laugh – however, I feel bad for the guy. Not only did he inherit the bubbled-up economy from his predecessor, but now he is also facing global inflationary pressures that, unlike his predecessors, he can not stop. This has led to a different kind of “decoupling” that most people are not talking about.

However, before I discuss the “surprising” inflation numbers (the cost of book publishing rose 1.7% last month!) that are the reason for this post (lest I forget and go off on another tangent) I would like to back up and provide some perspective on this.

First, let’s start from the beginning. Alan Greenspan, as Fed Chairman, chose to lower interest rates aggressively in response to the increasing economic weakness starting in 2000. But he didn’t just lower rates – he aggressively lowered rates and kept them low (fed funds rate, which is the rate banks charge each other to borrow money was at 1% for far too long). What did this do? It created a housing bubble.

The next problem that developed was the massive number of people who used their home equity as a virtual “ATM” (thank the good Bill Fleckenstein for that analogy) and spent all of it at Home Depot. Because they could borrow money using a HELOC (home equity line of credit) at a low variable rate of under 4% in some circumstances, they used it all. Fifty thousand dollar kitchen – no problem; saw a $100,000 bathroom on some ridiculous cable TV show and you want it – no problem – Greenspan provides.

Combine this aggressive monetary policy with the poor decision-making of the average consumer (e.g. taking out an adjustable mortgage with the ‘hope’ that they will be making more money in the future – I covered ‘hope’ as a financial strategy in this article Fantasy… ) and you get what we have now – foreclosures and pain – which I think is good but that is another conversation for another time.

Now back to Ben. I am quite certain he is a man of high intelligence. He just simply does not enjoy the power that previous Federal Reserve Chairmen possessed. Here is my thesis – I agree with the ‘decoupling’ of the US economy from the rest of the world but currently, only as it pertains to inflation. Later on, economic activity such as trade will probably decouple, but inflation is one thing that I feel is decoupling NOW. Here’s why (and why I feel bad for Dr. Ben):

The entire world certainly feels the price increases brought on by rising demand from the emerging economies such as China, India, Vietnam, and Kazakhstan. However, with our currency dropping in value against the rest of the world, we feel it even more. If our currency has depreciated 40%+ versus the Euro, then it stands that commodities such as oil have increased in price 40% more for us than for Europeans. This could very well continue.

So that brings us to today’s numbers – wholesale inflation – which rose 1% last month, about 2.5xs the expected figure according to this story (Link to Article). I’m surprised this number took this long to ‘surprise’ people. I have made this reference often, but my friend who owns a pizza store told me 3 years ago that cheese prices were going through the roof – only so long he can absorb the costs before he has to pass them on to customers (anyone see the Dominos Pizza story on this?). Have you noticed the price you pay for food, gas, oil, basically anything you need to buy? Stuff you don’t ‘need’ drops in price (e.g. desktop computers) but stuff you need goes up in price right? We have had this inflation for a long time and no one thinks about this until now.

And here is why Ben can’t do anything about it – THIS IS THE CRUX: in the past, inflation pressures came from overheated demand for goods and services but the USA was the primary consumer (see Uranium in the 1970’s for example) so by using monetary policy to slow down demand (raise rates and make it more expensive to borrow money for example or take currency out of the system thus banks have LESS to lend) we could control inflation by controlling US demand for goods and services. NOT ANYMORE. Does raising US rates affect the Chinese government’s cost to purchase cement for their massive new highway system? Does raising rates make India’s contract with electrical power grid companies such as ABB (Swiss company) more expensive? No.

So if Ben raises rates, he will probably not hold off inflation from global pressures. If he lowers rates to try to stimulate our economy, he could cause our dollar to drop further versus other currencies and INCREASE US inflation.

Who gets helped and who gets hurt by lower rates? Those with mortgages get helped and hurt (lower borrowing costs but inflation on heating oil, gas, food, electricity, etc.). Those who have savings get hurt (lower rates on savings deposits and higher inflation).

Conclusion: our only strategy may be to make sure we have diversified our assets globally especially exposing ourselves to other currencies. For those with a long term view, the continued weakness in real estate may present excellent opportunities in the next few years, since I think we have only begun to feel the pain. Comments?

 Chris Grande

  • I found your site on technorati and read a few of your other posts. Keep up the good work. I just added your RSS feed to my Google News Reader. Looking forward to reading more from you.

    Eric Hundin

  • Excellent synopsis of what is ailing US economy and thus global economy at large. Seems like a catch 22 situation. Loved reading ur anaysis. quite interesting

  • thanks for reading!