Tuesday, June 15, 2004

Monetary Policy Edition: Greenspan Taking System to Brink

In the past week some very distrubing news has come out. As I've commented on before, the Federal Reserve under Greenspan has taken an unusually accomodating monetary policy. Essentially they've been running the printing presses red hot. As Buttonwood commented on in The Economist the risk of inflation has to be balanced against that of economic growth.

But if inflation rises more than expected, the Fed would be behind the curve; and, worried that it is braking too late, financial markets would take fright. Something of the sort happened in 1994. Might it happen again? Certainly the Fed is starting to fret about inflation in general and about the inflationary impact of oil in particular. Alan Greenspan, the Fed's chairman, gave a warning this week that interest rates would have to be raised faster than expected if inflationary pressures intensified. In the broad sweep of history, says Russell Jones, chief international economist at Lehman Brothers, inflation has followed a fairly consistent pattern. A pick-up in inflation is preceded by a rise in the price of commodities, energy and food. That is what has been happening. Moreover, once inflation expectations become entrenched, inflation is hard to cure except by strong monetary medicine.

The inflationary expectations contained in the yields of ten-year index-linked bonds have risen sharply in recent months. If inflation really does spike, financial markets would fall apart: already-expensive equities would have to compete with higher interest rates and worries that America’s over-stretched consumers would have to tighten their (substantial) belts. Corporate debt, especially the stuff issued by highly leveraged companies, would look decidedly unattractive as those companies struggled with higher interest payments. Nor would other countries’ markets escape the fallout. Hardest hit would be emerging-market debt, which has already taken a pummelling this year.

But one thing is missing from the inflationary cocktail, says Mr Jones, to make it a truly potent mix: wage inflation. However you measure it, this is still mute everywhere, and offset, in America at least, by productivity growth.

Inflation can often pop up when economies first recover, only to fall later. For now, then, the most likely outcome would seem to be bad but not awful. Much will depend on how big are the spikes and how markets and the Fed react.

Greenspan has recently defined how he would act in the event of increasing inflation. In his confirmation hearings for his fifth term, he stated that the Fed remained ready to combat inflation if it should arise.
Federal Reserve Chairman Alan Greenspan, appearing on Capitol Hill Tuesday, offered an upbeat assessment of the economy and the outlook for job creation. He also held to policy-makers' current forecast that inflation should be relatively contained and thus any interest rate increases ordered by the Fed would be gradual.

If policy-makers' forecasts turn out to be wrong, the Fed will take aggressive action to keep the prices and the economy on an even keel, Greenspan said.

In truth it was already rising and the Greenspan had to have known this, and had to have known that he was gambling with the American economy in a breath-taking brinksmanship. The fact is that Greenspan is already significantly behind the curve of the interest rate policy moves of other countries.
Much of the industrialized world is shifting its economic foot from stepping on the accelerator to tapping on the brakes.
While high energy prices grab headlines, another economic trend - higher interest rates - will soon affect millions of people and perhaps the vibrancy of nations.

Sharply rising economic growth in several countries is forcing central banks to consider either ratcheting up interest rates or reining in money supplies to make sure inflation doesn't get out of hand. That will affect the cost of everything from home mortgages to business loans.

Inflation Rising

I've long complained about the tendency of inflation measures in the US to lowball actual inflation. However even these rigged government numbers such as the CPI and PPI are beginning to show Volcanic rumblings of rising inflation fears. Typically to keep inflation in check interest rates have to be higher than the inflation rate. Well the inflationary rate in the United States right now is an annualized 6% even by the tame government estimates. With short term interest rates at 1% there's no throttle control at all.
Consumer prices have risen at a 5.5 percent annual pace for the past three months, rippling from plywood to dairy section.

By Ron Scherer | Staff writer of The Christian Science Monitor

NEW YORK – A cab ride in New York now costs 26 percent more than it did a year ago.
In Omaha, Neb., the price of Oxboard, a stronger form of plywood, is up 187 percent over the past six months.

Since January, buying a $10,000 used car has cost about $320 more. Don't even mention the price of anything sold by the gallon.

If you think things are getting more expensive, you're right. While two months ago jobs were the biggest worry, inflation is now emerging as one of the main threats to the US economy.

This was reaffirmed Tuesday when the US Labor Department reported consumer prices rose 0.6 percent in May - the largest increase since January 2001. Over the past three months, consumers have seen prices rise 5.5 percent on an annualized basis - the highest inflation rate since the late 1990s.

"This isn't pretty," says Bob Gay, chief economist at Commerzbank Securities in New York...

Still, some economists are wondering if this year the Fed might have to reconsider this strategy. There is concern that energy costs will spread throughout the economy. Almost everything from plastics to medicines requires some form of petroleum input.

"The longer the price stays up, the greater the impact on the whole economy," says Sung Won Sohn, chief economist at Wells Fargo Banks in Minneapolis. "Maybe we're at a point where the Fed starts to look at the overall inflation rate."

Rising cost of a kitchen

For many Americans, the official inflation numbers may not tell the whole story. For example, millions of people will be buying a new home or redoing their kitchens this year. Yet the government's CPI numbers view the cost of housing in terms of rent, which is up 5.6 percent year over year. "For someone who is buying a new house or remodeling one, that is not remotely close or representative of the costs," says Gay. "I know. I've just renovated two of them and the costs are astronomical."

There are signs everywhere in the economy that in fact inflation, with the real figure at the 8-9% range I eyeballed earlier, is out of control. The story is going to have a very unhappy ending later with two outcomes. Either wage inflation ignites and inflation skyrockets with the Federal Reserve having to jack interest rates to the sky in order to bring them down - we're talking in the upper teen ranges easily. Or wage inflation does not ignite because of job market pressures but Americans feel a rapid erosion of their way of life. Imagine taking a 5% paycut instead of a raise year after year. After a few years of that, even prosperous families are going to start feeling the heat. Greenspan seems incredibly poised to destroy his own legacy.

In the latest news now the PPI is showing upward pressure even in the core rate.

WASHINGTON - U.S. producer prices shot up a hefty and more-than-expected 0.8 percent last month, the biggest jump since March 2003, as prices received for food and energy shot up, the Labor Department said on Thursday.

While food and energy prices both rose sharply, the department’s core producer price index, a measure of prices paid to farms, factories and refineries with these costs stripped out, gained a larger-than-expected 0.3 percent.

Economists polled by Reuters had expected a 0.6 percent rise in overall producer prices with the core index up 0.2 percent, and the report was likely to fan worry about the potential for a further rise in consumer prices...

Further back in the producer pipeline, cost pressures also appeared to be mounting. Intermediate goods prices rose 1.1 percent last month, while prices at the crude goods level gained 2.8 percent.

Of course Greenspan may weasel out of this yet. Things aren't irreparably broken yet. However Greenspan is taking a terrible risk. Inflation once out of control has a tendency to spiral. This is because there's a backload of money that get's real slack in the money supply once people realize that inflation is getting out of control. What that means is that when people realize there is no fiscal discipline they drop that currency and so this produces a secondary glut or loss of demand for the currency. With unaccounted for supply becoming flush on the market the currency has a sudden slack in the demand for the currency.

If Greenspan can dodge this bullet I'll be greatly surprised.


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