Inflation Watch: Early 2010

It is kind of interesting now. Aside from the very important fight to prevent the federal government from expanding their control over medicine, not much is happening. It is a lull. It is the eye of the storm. It is waiting for the other shoe to drop (and it could be a big shoe). It is the calm before…..well you get it.


If this were nearly any other time after WW2, we would be seeing business activity picking up, profits being made, people being hired. Instead, people are waiting. Sure the equity markets have moved up some. Obama has spent a lot, okay, he has spent a lot of a lot. He is going to be spending even more, even if the healthcare bill fails. But, banks are still not making loans. The last report on consumer credit showed a decline. The money supply quantity has been level for a while – it is a reverse hockey stick. The dollar, the price of gold, oil prices, and house prices are staying in a pretty narrow range. Of course, when the supports of house prices disappear, we may see something different. The Fed keeps talking about having to soak up all of the excess reserves they created, but a lot of people don’t think that they have the backbone, let alone the ability, to do it. What we are all doing is waiting. Waiting for the shoe to drop. We’re afraid that it will hit us on the head, hard.

There is some talk about production beginning to come back on line, about corporate profits growing and banks regaining their strength. Then, following FDR’s example, Obama says something that scares everyone (like the tax on banks to “recover” the TARP junk money), except his loyal followers, and decision makers, the wise ones, sit on their hands again. So, this period is one of uncertainty and pause.
We can be certain that everything that Obama has done and wants to do and what the Fed has done and will probably do are bad for us. The corrections that are needed because of the house price bubble have only partially occurred, at best. There is still a lot that could happen besides a house price decline. We could easily see more unemployment, and certainly see more non-employment, as Obama continues to take money out of the economy to fund non-productive, make-work jobs. It would take a lot of study to determine which was worse, unemployment insurance or Obama make work jobs. Not only are these people not producing which would move our economy toward prosperity, but money is being taken out of the economy to pay the unemployed not to produce. At least with unemployment insurance there is no pretense.

Even though the money supply numbers are coming up flat for the last several months, since production has fallen off, but prices have not, we are experiencing price inflation, at least enough to maintain prices. There may be some asset boom in the price level of stocks and gold, but not a lot. There is a lot of money sitting on the sidelines. There is talk of the “carry trade” in international asset markets. I am sure that there is something happening there. How big it is I don’t think anyone knows.
Since banks aren’t lending, added money is coming from direct government spending. Obama’s spending feeds directly into the consumer markets, therefore, to the extent that the money is being pumped, we will see pressure on prices. The direct spending is coming through the increased government payroll and things like non-employment programs and mortgage support. This spending is money that winds up in individual’s pockets and does not impact any specific set of prices. As general government spending continues to ramp up, the result will be more like “stagflation”, much like the 70’s where we had a stalled economy and rising prices. This will confound the “economists”, especially the Fed’s people. They are depending upon businesses being able to ramp up their production to meet the levels of money wondering around the economy. Businesses aren’t ramping. Banks aren’t lending, which is a really reasonable, business wise, good decision.

The Fed will be amazed that their magic wand, really low interest rates, doesn’t provide the wonderful result their models predict. We will be back in 30’s, or the 70’s take your unhappy pick.  (When you hear "low interest rates" from the Fed, always think: creating made-up money.)
The money for the government spending is coming from some U.S. “investors” who are frightened and think that federal bonds are safe. A lot is coming from foreigners, mainly central banks, who have trillions of dollars sitting there with nowhere to go except U.S. government debt. If the Fed does start mopping up money out of bank reserves, we will see short-term interest rates rise, which may affect the long-term bond rates. It depends on the conclusions reached by investors. If they think that the Fed is acting with some determination and will finish the task of taking nearly a $ T out of member bank deposits (this is the money that banks are forced to have on deposit with the Fed;  in government speak, it is called a reserve, but it isn't), then long-term bond rates may stay fairly flat, with the inflation premium pretty small. If investors think that the Fed is not serious or lacks the will to do the job, long-term rates will rise, and today’s buyers will suffer.

Maybe it would be worthwhile to talk about what makes up interest rates. As von Mises would say, the basic decision a person has to make is his preference for current consumption or future consumption, today’s goods vs. future goods. What does it take to get you to put off consumption? The classical answer that I have seen is something like 1 ½ to 2 %, that is, you would want an interest rate of return of say 2% a year to put off consumption, all things being equal. That is a wonderful saying by economists, isn’t it? “All things being equal”, because all things aren’t equal in a mixed economy. There are two added factors: inflation and taxes. (This is why government bonds have always been a bad deal, because after inflation and taxes they generate a net loss, guaranteed.)

What is your expectation for inflation? Up until 2007, the average for 10 to 15 years had been around 2%, using the CPI (don’t shout at me, this is only an example). Let’s say that your tax rate (federal only) is 33%. Using the basic, “natural” interest rate of 2%, you would want a nominal rate of return of 6% on your bond, i.e., after the tax of 33%, you had 4%, then minus the rate of inflation, you had 2% left. Today the 10-year bond is under 4%. In 2008, the social security people decided seniors should get an indexed increase of 5.6%. That tells you where things were headed, doesn’t it.

What is your inflation expectation of 2011 and beyond? More than 2%? Mine is. Taxes aren’t going down either (I will pause while you laugh.)………

If long-term bond prices go up, BO will have to spend more money financing his spending (doesn’t that make sense?), and he won’t be happy. He will point his finger at the Fed. Our hero, Bernanke, will…. And the story continues.

Back to my inflation watch, I am trying to avoid guessing or jumping to conclusions, here. I don’t see much hope. I think the question is how severe will things get. If they get more severe, will people demand that the government and the Fed do something different, like get there hands off the economy and also stop making money? We shall see.



To let you know that I am keeping my eyes as open as possible, I want to report that one of the standard indicators of the 20C suggests that we will not see more downturn. Hemlines have pretty much stayed where they were. Yes, for most of the 20C, when recession or depression hit, hemlines went down, adding to the personal sense of depression. However, either this indicator has lost its connection to the economy, or things will be fine, or at least the level of depression in the population will be a little lighter.



(Please give me some feedback if any part of this was not as clear as you want. I want to be sure that I am deciding to publish what an intelligent person will understand. Thank you. C.W.)