Fed policy to result in higher and higher inflation, what comes next?
Posted on 20 May 2008 with no comments from readers
Don’t listen to my humble ramblings, pay attention to what ECB President Jean Paul Trichet and ex-Fed chairman Paul Volcker are saying on inflation and current Fed policy.
Yesterday Trichet warned governments not to make the mistake of ‘second round effects’ on inflation which followed the 1970s oil shock and ‘enshrined the high level of inflation for a long time’ leading to mass unemployment in Europe.
Meanwhile,Volcker warned ‘if we lose confidence in the ability and willingness of the Federal Reserve to deal with inflationary pressures and to sustain underlying confidence in the US dollar, we’ll be in real trouble,’ and be ‘back in the ’70s or worse.’
In testimony to the Congressional Joint Economic Committee, he noted that in addition to having an effect on inflation, the US dollar is a ‘linchpin’ for the global economy and financial markets. If there’s a ‘real loss of confidence’ in the US dollar, ‘we’re in trouble,’ he said.
However, the Fed is stuck between a rock and a hard place. If monetary policy is too tight it will bankrupt home-owners and cause a meltdown in the banking system. If monetary policy is too lose then inflation will follow as night follows day.
The ‘second round effects’ that Trichet worries about are hard to avoid when inflation hikes food prices and people are starving. Governments either provide people with the cash to buy food or they are history. Food or lack of it explains most revolutions.
But I would certainly agree with him when he comments that the current fnancial crisis is not over and is an ‘ongoing and very significant market correcton’. Looking forward then what is to come?
Shoes still to drip include: the bond market which has not priced in inflation; global stock markets currently supported by over-optimistic profit forecasts, inflation will squeeze profits; and employment, which is a lagging indicator as companies are reluctant to fire their workforce.
However, the very last shoes to drop will be in the commodities complex. Industrial commodities will weaken in price as demand contracts but the evidence of the 1970s was that commodity prices keep on rising under conditions of ‘stagflation’ or low growth and high inflation.
Why is that? It is pure monetarism – the forgotten Thatcher and Reaganite mantra of the late 70s which I opposed vigorously as a young Oxford economics student and now realize was completely correct. Indeed, I can recall suggesting monetarism might after all be valid to Roy Jenkins over a dinner and being shouted into a corner by this normally mild mannered man.
Monetarism was controversial then and it will be again. But it is all very simple. If the Federal Reserve expands the money supply – and M3 is growing by 20 per cent although not published any more for obvious reasons – then more money is chasing the same number of goods and prices go up.
It is most easy to understand in the commodities complex. If there is more money in circulation – and asset prices like houses are going down and not up – then the price of hard assets like oil, gold or even steel are forced up to accommodate the newly printed cash.
Look at this another way: If you could accelerate the supply of commodities at the same rate as increasing the supply of money then prices would remain static. But that is not what is happening.
The Fed is deliberately and consciously causing inflation by pumping money into the global economy to keep the US financial system afloat through a housing crash.
But this is not going to end nicely – a painful shake-out will happen one way or another, and housing is just the start not the end. We have bonds and equities still to come, and then a long recession when markets have bottomed out.
no Comments posted by readers:
Peter.
Don’t you think that the $billions in CREDIT CONTRACTION due to bankrupt banks, companies, individuals, high libor, high euribor, etc, etc,causing precipitous falls in lending, ie CREDIT CONTRACTION, is DEFLATIONARY?
Which is moving faster, the credit contraction mentioned above, plus no more house-equity withdrawals, or the growth in money supply?
If the speculative money currently in oil (and wanting a GOP win), is moved, and oil falls, where will it go?
I reckon commodities, possibly equities, (South East Asia).
We must factor in the levels of manipulation going on here, via the futures markets.
The fed is out of control, and acting illegally. (Bear Stearns) Anything goes to help the banksters, including screwing the population. But then, it was the Fed that caused these problems in the first place, deliberately.
If China wishes to ride out this storm, her currency should be let rise slightly to mitigate imported inflation, and her population encouraged to consume a little more. She is already making nice strategic moves re agricultural land purchases, and mineral rights around the globe, and equity stakes in global mining companies. These moves will give China a large voice in the future effect of global inflation on China.
Meanwhile the US rattles the sabre globally.
Go figure!
Thanks for a thoughtful comment! The deflation of the asset classes you flag up just pushes all the inflation into what is left, so you do have both inflation and deflation going on at the same time. I am afraid Chinese equities have crashed by 50% since the sub-prime started and China is going to fall apart after the Olympics – that might make a buying opportunity but not just yet. Money will flow to oil and precious metals like in the late 1970s – and we have already seen the start of it. But the Fed’s monetary policy is wholey to blame for this mess.
“But the Fed’s monetary policy is wholey to blame for this mess”.
Sometimes this man raves. Sometimes he gets it right. Either way, worth a read.
This article carries implications for all western societies, and for future resource wars, population movements, and liberty and freedom. It alters the perception of the second half of the slanting bell-curve of oil depletion in a distinctly frightening way.
If the money supply gets increased, but is not made accessible, what effect does that have?
Isn’t that what happened back in the late 20s?
The general population (aka consumers) faced unemployment percentages that shot up over 25%
Inflation made goods too pricey to sell and excess and waste ensued while people struggled to survive in tents, despite so many houses standing empty.
In a move that possibly prevented an American revolution, FDR made a new deal, with the bankers. Borrow your way out they said. Put people back to work while building up the infrastructure (and the national debt). All the while Adolf ‘Bin Laden’ Hitler was getting financed by the bankers too, and the corporations were selling America’s war-making resources (like oil and copper) to Italy and Japan. In the summer of 1941 the US finally stopped selling oil to Japan, which was a big part of Japan’s decision to attack Pearl Harbor, fearing America’s intervention with Japan’s quest for securing oil-rich areas of the south pacific.
No need for a draft, the signs of the times are changing, ‘Will work for Food’ is going to be replaced with ‘Will join the army for food’
Precious metals are a sound store of value.The problem in the future I think will be hatred of our freedom to choose between fiat money and gold.A democratic decision as to what we do with our substance shall not be tolerated for long, speculators will be blamed and wealth confiscated.Imagine the rage of government employees who have salaries and pensions in wortless currencies.Is it not inevitable that they with rightious indignation shall invoke irrefutable socialist arguments regarding the evils of capitalism?
MoneyWeek says today:
Why, oh why would anyone buy a bond or a gilt? You might get yields of 3%, 4% or 5%, but the cost of living is patently rising by so much more than that. Virtually guaranteed to lose purchasing power, it just doesn’t make any sense.
So why are people buying them? It’s because bonds are perceived as safe. But I can’t help but think now that the inflation genie is out, more and more people will come to realise the truth about the declining purchasing power of their money and move their funds elsewhere.
There’s been endless talk of commodities being in a bubble. Oil is in a bubble, we hear. But supply has to exceed demand in a bubble. In the case of oil, it doesn’t. Last February for the first time in the history of the world demand for oil exceeded production – that situation has remained the case for 90 days. But there is no supply shortage of bonds. And you have to question the real value and use of the underlying asset.
The bubble, if it’s anywhere, is in bonds and they, in my humble opinion, will be the next one to pop.