THE ECONOMIC WORM TURNS FOR THE FED

Those of you who were thinking the financial markets’ big problem was the credit crunch can be forgiven for feeling a tad confused by the sudden media election of inflation as the next big bugaboo. The repercussions in the credit markets, after all, are still echoing down Wall Street: To chose just one example, Goldman Sachs recently reversed its view that the worst was behind the financial markets, advising its clients to lighten their financial holdings—not buy more.

According to the June 17 Goldman report, financials are likely continue to languish, because in their view, credit deterioration won't peak until next year, and raising capital has become more difficult because most of the deals that have been done have performed poorly.

Bank, brokerage and insurance stocks, the third largest of 10 industries in the S&P 500, fell 19 percent from May 5 through June 20, more than any other group. Consumer discretionary was the third-worst category, dropping 8.4 percent, against a 6.4 percent slide in overall Index during the same period. Finance-related activity comprises about 25 percent of the US economy.

But while the urgent problem facing the global economy was the credit crunch that took off last August, the current problem is global inflation. In part, this is because to defrost the credit freeze, central banks around the world poured as much as $1 trillion into the financial system. Now it’s sloshing around the globe, looking for a home at a time that financial assets are worth less than they were. That’s one element of the inflation problem.

The other, of course, is the price of oil, which is driving up the price of virtually everything but junk bonds, and as a result, driving down corporate earnings as people stop buying $300 jeans so they can get to work, feed their children, and stay warm in the winter.

This is no laughing matter. While some inflation is inevitable—and, by the way, good for real estate investors, since money borrowed today is paid back tomorrow in less valuable dollars—serious inflation is very difficult to control and poses political as well as economic problems: If inflation gets out of control it eventually becomes hyper-inflation, which destroys economies and, typically, governments.

It was hyper-inflation, after all, that paved the way for Hitler’s rise to power in Weimar Germany. In this country, hyper-inflation undermined the ability of the Continental Congress to wage war. Today, Zimbabwe has hyper-inflation.

Killing inflation means bitter medicine: The last time the United States had a bad round of inflation, in the early 1980s, Fed Chairman Paul Volker had to drive interest rates to 22 percent, provoking a nasty recession.

That inflationary spate was caused by a slowing economy and a sudden spike in oil prices. Sound familiar? But this time, things are arguably worse, because of the enormous amounts of money that’s been poured into the financial markets.

At this point we have to stop for a brief discussion of the two ways to measure inflation, prices, or CPI (consumer price index) inflation, and monetary inflation. While the former is how the government and the media measure inflation, the financial community favors the latter

because it feels the CPI measurement has become deeply politicized--if only to save the government money in the form of increased Social Security and Medicare payments--and therefore under-estimated by at least 1 percentage point.

An astute, if somewhat abstruse, explanation of why the financial community thinks this is available by following this link, which will take you to the monthly commentary of Bill Gross, chairman of the world’s largest bond fund, PIMCO (http://www.pimco.com/LeftNav/Featured+Market+
Commentary/IO/2008/IO+June+2008.htm).

Meanwhile, we’ll explain something about monetary inflation, which is how many professional economists measure inflation. The theory behind this measurement goes back to 1971, when Richard Nixon took the US Dollar off the gold standard. At the time, the theory was that the real value of the Dollar wasn’t based on an ounce of gold (then fixed at $35 per ounce), but the value of the American economy.

By this reasoning, on the day the Dollar was floated off gold, there were X Dollars in circulation, a Y gross national product, each individual Dollar was therefore worth that specific fraction of the gross national product, and inflation could be measured by comparing the growth of the economy versus the growth in the M-2 money supply (composed of currency, traveler’s checks, demand deposits, retail money market funds, savings, and small deposits).

From December 1998 to December 2007, M-2 has grown 69.6 percent, while the gross domestic product (as the economy is currently measured) has grown 58.24 percent. Thus according to this measurement, total inflation in that period has been 16.32 percent, or 1.8 percent. This is not so bad.

However, growth in M-2, and therefore inflation, has been accelerating. Last June, before the credit crisis began, M-2 was growing at a 4.9 percent annual rate; this June, it was growing at a 6.4 percent annual rate, at a time that GDP growth is stalled, at best, and is probably shrinking. Thus, inflation, measured this way, is serious, and since, whether you think it’s a good measurement or not, CPI inflation is likewise growing, we can expect the Fed to begin raising interest rates to fight it—although not until after the Presidential election.

The Fed will eventually have to raise rates anyway, since the rest of the world’s central banks are raising theirs, and, at a minimum, we need to sell our debt in the world market in order to finance our budget and trade deficits. To the extent that the Dollar is falling against most other currencies (the major reason oil process have spiked, since the oil business is conducted in Dollars), and we need to compete against other governments’ securities to sell our own, we need to raise the interest rate of our Treasuries.

Since the economy is slowing —if not shrinking—this necessity comes at an awkward time, to say the least. It will further slow an economy based on consumer spending, at a time that consumers are, very rationally, cutting back on their spending anyway. This in its turn could create a self-reinforcing economic phenomenon.

This is why inflation is suddenly the big deal. It’s serious, being driven by forces outside the control of central banks, and nothing to sneeze at. What the media are not doing is trying to distract us from the problems of the credit markets; there will be more of those, and we’ll be hearing about them as they arise. But they need to tell us everything that’s going on.