‘The road to hell is paved with good intentions’ is a proverb coined centuries ago, but today’s Federal Reserve (Fed) should take note when it does its own coining.
Fed Chairman Ben Bernanke is in a tough spot; despite his best efforts to convince the markets of the opposite, he may well be the catalyst for substantially higher inflation as well as a substantially weaker dollar. What we are experiencing may be the beginning, not the end, of inflation.
Recently, Bernanke gave two pep talks on the dollar. The market humbly obliged and provided the greenback a boost for about two days. Many observers noted that the Fed rarely ever talks about the dollar and instead leaves this up to the Treasury.
While this very much applied to Bernanke’s predecessors, Bernanke has been seeking the discussion about the dollar ever since becoming chairman. In his academic publications before joining the Fed, Bernanke extensively discussed how a weaker currency during the Great Depression would have alleviated the hardship on the people. The dollar is an integral monetary policy tool for Ben Bernanke, make no mistake about it.
The two recent talks by Bernanke were the culmination of a series of talks by other influential Fed officials. It turns out they were aimed at cushioning the impact of European Central Bank (ECB) President Jean-Claude Trichet, who subsequently announced that the ECB will quite likely raise rates at its next policy meeting to pre-empt the "secondary effects" of inflation; these secondary effects of inflation refer to the spreading of high commodity prices as inflation in other sectors of the economy.
Unlike the Fed, which these days mostly talks tough but acts soft, the ECB has the credibility that it will keep the monetary leash tight. Trichet’s comments crushed the rally and undid the hard work by the Fed to talk up the dollar; it may have been much worse for the dollar had the Fed not tried to woo the markets.
What this episode shows is that the Fed and the ECB at least talk and provide a heads-up on announcements that may rock the markets.
In recent years, monetary policies in Europe and the U.S. have pursued rather different policies; the ECB very much disagrees with the aggressive rate cuts pursued in the U.S. At some key events during the credit crisis, the Fed and ECB acted without consulting one another.
Aside from merely trying to support the dollar, Bernanke’s comments suggest that he — at least in my humble opinion — is wrong about inflation and the dollar. Bernanke is clearly surprised that the weaker dollar has contributed to a surge in inflationary pressures.
The models of numerous economists at the Fed have shown that a weaker dollar in past economic cycles has not been linked to substantially higher inflation in the U.S. The grave danger with economic modeling is that modern monetary history is simply too short to cover a satisfactory set of different economic environments; over and over again, central bankers are some of the smartest economists of their time yet make new mistakes (or worse, the same mistakes all over again) just when they thought and publicly proclaim that they have learned from history.
Until early 2007, the weaker dollar did not cause much inflation, but import prices are up more than 15 percent year-over-year; even excluding food and energy, inflationary pressures are piling up throughout the value chain.
Inflationary pressures have been building for years on goods and services that could not be imported, such as the cost of education, healthcare, and services, like local craftsmen. Because policies fostering global overproduction — easy credit, low taxes in the U.S., as well as Asian policies that include subsidizing exports through weak exchange rates — flooded American consumers, consumer prices remained low for a long time. However, the same global overproduction has caused commodity prices to go through the roof.
Asian economies are far more sensitive to surging commodity prices than is the U.S. economy. Starting in early 2007, then, Asian producers could no longer absorb surging commodity prices and other inflationary pressures but had to start passing their higher costs on, namely to American consumers.
And what should be to no one’s surprise, we have started to build new manufacturing plants in the U.S. to export sneakers to Vietnam, just because our imports are more expensive.
While the world scrambles with the impact of inflation, Bernanke gives his view of what has caused inflationary pressures to build. While we agree with much of his analysis, we beg to differ with his comfort about the outlook.
Bernanke says this time is different (from the 1970s) because the U.S. economy does not experience the same wage pressures. Darn right he is: U.S. consumers are exhausted; 20 percent of homeowners are insolvent, i.e. their homes are worth less than their mortgages. Jobs are difficult to come by as the economy is unlikely to show significant growth in light of Fed policies that, amongst others, allow financial institutions to park their bad reserves with the Fed rather than to clean up their balance sheet right away.
But to conclude that, as a result, we won’t have a further buildup of inflationary pressures, is misguided. What it means is that fighting inflation would be orders of magnitude more painful than when Paul Volcker squeezed inflationary pressures by hiking interest rates to 20 percent.
While it was tough in 1981, that’s simply not an option now without throwing the country into a depression.
This time around, inflationary pressures are likely come from imports as Asian countries allow their currencies to float higher to combat inflation; already these countries are abolishing domestic energy subsidies. Giving in to pressures to allow currencies to float higher will reduce the cost of imported commodities.
We have discussed in the past how we believe that Asian countries producing goods at the higher end of the value chain, such as China, will be best positioned to pass on higher costs. American corporations are likely to react to an ever-tougher environment by outsourcing even more. As most basic production processes have already been outsourced, more sophisticated operations may now follow suit.
It is China that benefits the most, as China is — in our assessment — the only country that has the skills, infrastructure, and capacity to absorb the next generation of outsourcing projects.
We are already at a stage where many consumers do not have the money for basic necessities, and the Fed has not done anything to tighten monetary policy.
This time is indeed different from the 1970s as the Fed’s hands are tied; it cannot combat inflation without causing a severe recession, something we do not think the current composition of the Fed is willing to accept.
Instead, the Fed would love to have higher nominal housing prices to bail out consumers, i.e. it welcomes inflation. Indeed, it may love to see some wage inflation, so that it could at some point down the road try to balance the monetary system through tightening.
For now, we have a Federal Reserve that does not want a recession but a Fed unwilling to accept a recession will get inflation. At the same time, some Asian countries as well as Europe will fight inflation. As a result, we believe we have only seen the beginning of inflation and that the dollar may have a lot further to go on the downside.
As a final note, as political pressure builds to restrict “speculation” in industrial commodities, any measure may only deepen the trouble for the greenback.
Speculative money flowing into soft and hard commodities is money seeking a safe haven from inflation. If policymakers take away choices to diversify, the remaining choices will benefit. Notably, gold may well benefit, as we very much doubt policymakers will restrict the hoarding of gold, given its insignificant industrial use. The dollar may suffer as selling dollars may be one of the few inflation hedges left if investors are restricted from buying commodities.
The Fed certainly means well. But policy makers may be blinded by past academic studies that give them a false sense of comfort. They are also prisoners of their own policies, policies that extend the agony in the financial services industry. As a result, institutions may be reluctant to extend credit, a key ingredient for economic growth.
A patchwork of initiatives, all with the best intentions, may unintentionally pave the way to the proverbial inflation hell.
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