Tuesday, June 24, 2008

More Inflation Shenanigans

I've had this post brewing in me (is that what they do, exactly, brew?) since I got home from Spain.

In my previous post on monetary policy, Fire Sale, I highlighted indicators of the effects of the Fed's disasterous monetary policy as reflected in the most recent run up in the price of oil (or should I say decline in the value of the dollar). In that post I predicted what the future indicators were that this cycle was playing out as an indicator of Fed's causing of inflation, namely that the initial profit surge seen in the economy due to export volume would have to cease and be followed by subsequent rise in the prices of products.

Once again, it seems, my blogging life has intersected with my professional life, as on 5/28, CEO of my company Andrew Liveris, announced a broad price increase on Dow's products of up to 20% due to rising raw material costs, namely crude oil, and energy. Dow is a perfect barometer of the effects of monetary policy as it's primary feedstock, oil is denominated in dollars and will see the effect of inflation of the dollar. Several petrochemical companies have followed suit with similar announcements. This is the first step of the inflationary effect and it took about a quarter or two to manifest itself in the first step on its journey toward the consumer. Give it another two to three quarters to manifest itself broadly in the economy. Recognize that prices are going up in a depressed economy which means demand destruction, and stagnation soon follow.

And our illustrious Fed? What was it doing at the same time? As a June 5th Wall Street Journal Editorial, "The Buck Stops Where?" pointed out, after several years of rising commodity prices, and falling dollar valuations, relative to major currencies that aren't pegged to the dollar, it seems the Fed and Chairman Ben Bernanke has now expressed concern over possible inflation.

This week current Fed Chairman Ben Bernanke waved the white flag over Mr. Volcker's point by declaring his own public concern "that the dollar remains a strong and stable currency." Apologies accepted, provisionally.

The tragedy is that this is big news. The Fed has monopoly power over dollar creation, and concern for its value ought to go without saying. Yet so great has been the Fed's dollar abdication in recent years, and especially since last summer, that Mr. Bernanke's words have come as a great global relief. As the dollar has strengthened in welcome response, the price of gold and oil has fallen in each of the last two days.

[Ben Bernanke]

The question now is whether the Fed will follow up its new words with action. "We are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations," Mr. Bernanke said on Tuesday, a sign that the Fed may be waking up to the inflation threat. But the Fed chief also signaled that he isn't about to tighten monetary policy any time soon because current "policy seems well positioned to promote moderate growth and price stability over time."

Price stability where? Not in the U.S., where every economic report shows rising price pressure...

The Bernanke Fed has also been oblivious to the fact that it runs a global dollar bloc. Central banks in dozens of countries peg or otherwise link their own currencies to the world's reserve currency, which is the dollar. They do so for the sake of exchange-rate stability, which helps with trade and investment flows. They essentially subcontract their monetary policy to the U.S. central bank.

The Fed's dollar indifference has sent an inflation shock through those dollar-linked economies. This week alone, we've read about price riots in Vietnam; inflation hitting 10.1% in Kuwait; Abu Dhabi contemplating price or wage controls; South Korean and Indonesian central bankers considering rate hikes; and the Chinese letting the yuan rise ever higher to curb inflationary pressures imported from the U.S.

Many of these countries are now delinking from the greenback. Meanwhile, the dollar plunge has translated into a net transfer of trillions in wealth from the U.S. to the rest of the world. The result has been the largest decline in America's global economic influence since the 1970s.

If the editorial language strikes anyone as incredulous, it's no surprise. While oil prices dropped on this news, they were soon back up. I'm not sure why they would have dropped in the first place since Bernanke's stance to not tighten monetary policy belies its complete misunderstanding of the situation. In a June 18 follow-up "FED Mood Titls Away from Rate Increase" it's clear that this inflationary pressure does not worry the FED as much as it might think.

As the editorial points out, the FED has complete control over inflation of the dollar. If there's inflation out there, it is due to inappropriate monetary actions by the FED. Notice how in most of the FED's language it treats inflation as some causeless effect out in the world. As such the FED's action to curb inflation are never viewed as self-correction, but rather as attempts to keep the unruly market in check.

The misguided policy is that the FED wishes to believe that it's stimulatory actions (keeping interest rates low) will "stabilize" the housing market before it has to deal with inflation. But let's go back to our lead story and price increases. It takes time for prices to trickle through to the consumer. When it does its destabilizing effects will overwhelm any stimulus the FED thinks it's injecting in the short term. Inflation has already been unleashed, and is a torpedo headed for the housing market. Since the FED is the only agent that can act to head it off, keeping a "steady as she goes" monetary policy is a recipe for disaster! If the housing market is bad now, it won't be helped when the cost of materials that go into new starts and renovations skyrockets, as it is sure to do.

Congress isn't blaming the Executive Branch for failed monetary policy. Instead it's hauling oil company CEO's before committee's and proposing laws to regulate "speculators"

And today we have an even larger signal of this effect as in no less than 3 weeks after it's first announcement, Dow has again announced broad pricing increase of up to an additional 25% on it's products. Including these increases and the ones most chemical companies have been making over the last 12 months that's more than doubling of prices!

The FED will not make substantive moves (whole digit percentage points move upward in interest rates) until the furor over inflation reaches a deafening roar. It will not do so because it believes it is helping the situation instead of the primary cause of it. It misunderstands its own cause and effect and the consequences will be disastrous. It doesn't see that it has launched the inflation torpedo now working its way through to consumer product prices. Leading indicators of this? Look at airlines and chemicals. Airlines are highly dependant on oil, and are a direct pass through of oil costs to the consumer. Chemicals are only one step removed from oil, and manufacture products that are ubiquitous in almost all downstream markets. Both these industries are reeling with price increases and reduced demand.

The FED will make time-delayed reactionary moves. Free markets on the other hand act in an anticipatory manner moving ahead of the impact based upon actual cause and effect. This in fact is the best empirical case to be made for privatization of monetary policy. Businessmen cannot afford to wait until a crisis exists to act. They must anticipate it. As long as the FED is oblivious to its own shenanigans, it cannot act in this fashion.

The cure is known, and can be enacted now, but it is not popular. It's essentially a tightening of the money supply, as was effected by the Reagan FED to head off stagflation of the late 70's, and it rests primarily in the hands of our money regulators. If the free market were running monetary policy it would already be in effect. Of course one could argue that we never would have gotten into this mess in the first place.

Lasseiz faire!

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