Monday, April 5, 2010

How Many Fed Governors Can Dance on the Head of a Pin?

There has been endless debate among market observers about whether the fed is diligent in fighting inflation. Some say inflation is nowhere in sight, indeed it is all but impossible to get inflation with a high output gap, i.e., when US production is so far below full capacity. Others say that rapidly increasing money supply raises the risk of inflation down the road, and that commodity prices may already be signalling higher inflation expectations. Given this diversity of opinion, it seems impossible to reach a consensus on the risk of inflation and the fed's willingness to keep inflation at bay.

Of course, financial markets over the last 15 years have proven to practice a form of selective amnesia when it comes to the desire for easy money. They rationalize away the fact that, our central bank has not only failed to fight inflation, it has repeatedly encouraged it during the Greenspan/Bernanke era. First in the form of a stock market bubble, then as a combined housing/stock bubble. No sooner does one burst than the fed busily sets about creating the next. These bubbles are simply inflation forcing its way into whatever asset is most amenable, sometimes with a little encouragement from the government.

What the deflationists fail to acknowledge is that our reserve currency status has been the only thing preventing broader US inflation for two decades. Foreigners lent us money cheap and we bought their cheap goods. Meanwhile, our internal cost of doing business has risen, making our goods increasingly uncompetitive in the global marketplace. But now, our status as a poor credit risk has been exposed by the massive housing defaults. The era of cheap foreign credit is gone, thus so are the cheap foreign goods. A strong currency would be helpful, but we don't have anything the rest of the world wants.

During this process there has never been a period where the fed could be accused of being too restrictive. The concept of "taking away the punchbowl" is completely outmoded for modern fed policy. We're so addicted to free dollars now that the idea of high interest rates is laughable. The stock market would drop and consumption would follow. Bernanke, like Greenspan before him, much prefers being a "rock star" for the markets. The accolades for his daring market rescue are Ben's morphine. Hard money would be naloxone for Bernanke and the markets. It's just too painful all the way around.

Look at what's taking place. Consumer discretionary stocks are soaring, many hitting all time highs. The Nasdaq 100 has recovered almost all of its decline from the peak of the liquidity bubble in 2007. Commodity prices are soaring across a broad range of assets; industrial metals, energy, agricultural. Oil prices are at a level never seen before 2007. Emerging economies, among the first to feel the effects of dollar inflation are booming. And as all this happens, Ben Bernanke says he will keep interest rates at zero "for an extended period of time". Left unsaid, is that if the equity market drops, he'll begin printing money again.

Federal Reserve policy is inflationary. It has been inflationary for a long time. It is explicitly guaranteed to be inflationary for a long time to come. It is already causing inflation and that will only get worse. Free money is inflation by definition. Any debate to the contrary is either self-serving or simple minded. Like the stock touts say, don't fight the fed.

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