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Forex Blog - Whip Inflation NowWhip Inflation Now
June 13, 2008Whip Inflation NowWhere Can We Get Help on Inflation?The Patient Died AnywayInflation in Asia and EuropeThere Are No Good Solutions
President Nixon instated price controls on the 15th of August, 1971.
Inflation was a little over 4% at the time. Price controls manifestly
did not work (resulting in shortages of all sorts and a deep recession)
and were rescinded a few years later. President Ford went to Congress
with programs to fight inflation that was running closer to 10% in
October of 1974, with a speech entitled "Whip Inflation Now" (WIN). He
famously urged Americans to wear "WIN" buttons. That policy too was
less than effective, and the buttons, in a history replete with silly
gestures by governments, should stand on anyone's top ten list of such
Cynics more thoughtfully wore the buttons upside
down and said the inverted letters (which looked like NIM) stood for
"No Immediate Miracles." They were right. There was no miracle, just
eventual pain and lots of it. Ultimately, Paul Volker defeated
inflation, but at the cost of two serious recessions and a lot of
economic misery, with unemployment levels over 10% for nine months in
This week we were given the data that inflation as measured
by the Consumer Price Index (CPI) over the last year was 4.2% and
unemployment is now 5.5%. Some call for the Fed to raise rates so that
we do not have to experience another lost decade like the '70s and then
ultimately see some future Volker forced to raise rates and drive
unemployment back to 10%. Others suggest that "core" inflation is what
should be paid heed to, and urge caution.
This week we look at
the cost of what could be a renewed effort to Whip Inflation Now, not
just here but in countries worldwide. Will Trichet in Europe raise
rates even as the European economy seems to be slowing down? If you
think inflation is bad in the US and Europe, take a peek at Asia. And I
ask, "What will Ben do?" It should make for an interesting letter.
Whip Inflation Now
and his advisors thought inflation at 4% was serious enough to
institute price controls. Headline inflation in the US is now 4.2%.
What kind of economic policy should we pursue to bring inflation back
into the Fed's comfort zone of 1-2%? Would it work and would it be
worth the pain? To get a handle on the question, let's go to the data
from the Bureau of Labor Statistics and see where inflation is coming
And let me note, this is the same exercise we could do for
a host of countries. The answer will be roughly the same: there are no
Core inflation, or inflation without food and
energy, grew at 2.3%. Inflation without food costs was an even 4% and
without energy was 2.7%. Clearly energy was the leading contributor to
inflation in the past year.
But the recent trend in rising
inflation is even more worrying. If you look at just the last three
months of data and compute an annualized rate of inflation, you find
that overall inflation has risen to 4.9%, energy inflation is running
at a staggering 28%, and food costs have risen 6.2%. Meanwhile, core
inflation during that period dropped to 1.8%. You can see all the data
gentle reader, let's think about these numbers. Food (over 14%) and
energy (over 9%) combined make up roughly 24% of the CPI, yet were
responsible for over 60% of the recent three-month trend in inflation.
By the way, housing was up 4.9% and transportation up 8.7%, so it was
not just food and energy.
What would it take to drop headline
inflation back to under 2%? Well, one way would be for food and energy
prices to fall. Let's look at the possibilities.
As Donald Coxe
has noted, North America has had an 18-year run of remarkably good
weather in our growing season. You have to go back 800 years to get a
string of years that were that good. Yet today food reserves of all
types are at decades-long lows. There is very little room for any type
This growing season is not off to a good start. It
looks like the yield on the corn crop will be lower than normal, and
that is if we get very benign weather this fall. Given how late much of
the US corn crop was planted, and how torrential rains in the corn belt
have devastated crops (not to mention flooding cities, and our thoughts
and prayers go out to those who have lost their homes to flooding), an
early frost would be disastrous.
Because we have devoted so much
of our arable land to corn (in a very misguided policy to turn food
into ethanol), we have less for soybeans, which is putting upward price
pressure on beans and other grains that are used to feed cattle, hogs,
chickens, etc. In fact, it costs so much to feed livestock that
ranchers are shrinking their herds.. This means more meat is coming
into the system now, which is dampening prices. Increased supply will
reduce prices in the short term, but next fall we will find that
supplies of all types of meat will be short. That will potentially send
meat prices soaring. Cereal and bakery products are up 10% over the
last year. They could continue to rise in the fall if the corn crop
does not yield more than currently projected. It will cost even more to
feed your household and feed the animals we need for meat.
is the most basic of commodities. Demand is fairly consistent, and
supplies may come under pressure. Looking for food inflation to drop
back by the fall to 2% is not realistic in the current environment.
about energy? There is some more hope there, at least on the oil front.
High prices have reduced demand in the US, with gasoline usage down
I think we have reached a tipping point. The psyche
of the US consumer has been permanently scarred. Slowly, this country
is going to replace its fleet of cars with smaller, more fuel-efficient
cars. Over time, we will see demand continue to fall. We could see
further drops in the demand for gas in the next few months.
of Asia used to subsidize oil prices to their consumers. That is
changing, as Indonesia, Sri Lanka, and Taiwan have announced they are
decreasing their subsidies, as the cost is simply too much. Malaysia
now spends 25% of its budget on oil subsidies, and must raise prices or
cut other services - or watch inflation get worse. India is now
contemplating how to cut its subsidies. Even China is likely to start
to raise costs after the Olympics. These countries are going to go
through their own price shocks. All this will reduce world demand for
And while there are those who are convinced the high price
of oil is due to speculators, there are reasons to think the real
culprit is still demand. Refiners are paying anywhere from $5-7 more
per barrel than futures prices for "light sweet" crude (oil with low
sulfur content) and $7 less for heavy sour crude. Much of the oil from
the Middle East is of the latter variety, and supplies are increasing.
There is not enough refinery capacity for heavy sour crude. That is why
you see OPEC representatives say there is enough supply. For the crude
they produce, there is. Spot prices are reacting to supply and demand
and not speculative futures prices.
Over time, reducing demand
should reduce price. I would expect to see oil get back to $120 or
lower by the end of the year. But by year-over-year comparisons,
inflation will still be ugly for some time. Oil prices have risen
approximately 90% in the last 12 months (the actual percentage is
highly dependent upon which measure you use). The bulk of that has been
in the last four months. For energy inflation to go down on a
year-over-year basis, we would need to see oil drop below $100. How
likely is that in the next two quarters?
Where Can We Get Help on Inflation?
the two main sources of inflation are unlikely to drop in the next two
quarters. If we want to get overall inflation down to 2%, we will need
to look for help in other areas of the economy. How about medical care?
Not likely. Education costs? Get real.
Housing costs make up 42%
of the CPI, and thus are the biggest component. That is broken down
into several categories: owners' equivalent rent for those who own
their homes (32%), actual rent for those who do not (around 6%),
utilities, furnishings, etc.
Rents have been up by 3.5% over
the last year and owners' equivalent rent by 2.6%. If rent increases
were to drop to zero, that would just about get us to 2% overall
inflation. But let's think about that. Such a low number would mean an
economy on its heels and a lack of buying power on the part of
consumers. The only way that happens is with serious unemployment.
You can go to http://www.bls.gov/news.release/cpi.t01.htm
and look at the various components of the CPI. Spend some time thinking
about what costs are likely to drop. New and used vehicles are now
dropping year over year, but only by a little, and that is only 7% of
the index. Most items are rising at least a little.
Now, in a
second thought exercise, think about what would happen if Bernanke
decided to raise rates. A rising Fed funds rate is unlikely to have
much effect on oil or food prices, unless he raises them enough to put
the US and world economies in a serious recession.
would he have to raise rates to really slow the rest of the economy
down? If you push up rates by 2% with the economy either in recession
or close to it, you risk putting the economy into a much deeper
Look at the yield curve below. This is exactly what
the banks and financial services lend. They like to have a nice
positive differential between the cost of their deposits and what they
can charge for lending.
you raise rates by 2%, you would more than likely invert the yield
curve, making it that much more difficult for financial service
companies to be able to recover. Given that they are already in
trouble, and therefore less able to lend to businesses and consumers,
do you really want to make things worse?
Look at the banking
index below. This is an ugly chart. Another inverted yield curve would
do serious damage to an industry already reeling. We are going to see
more write-offs from banks. This chart will get uglier, but it will
collapse without a positively sloped yield curve. (chart courtesy of www.fullermoney.com)
raising rates would make it more difficult for consumers whose mortgage
rates are tied to short-term rates. Is that what a housing industry
needs right now?
Bottom line, Bernanke is in a very difficult
position. Inflation by any standards is too high. But the cause of the
inflation is not something in the Fed's control. To bring inflation
back to 2%, he would have to savage the economy, perhaps at least as
much as Volker did. Do you want to see unemployment go to 8-10%?
was dealing with wage inflation. Everything had cost of living
adjustments (COLAs) back in the late '70s and early '80s. Spiraling
wages were one of the primary causes of inflation, if not the most
important. A higher Fed funds rate could do something about rising
wages by increasing the unemployment rate. Tough love, but effective.
had to kill inflation expectations. Today, that is not (so far)
Bernanke's problem. If you look at the implied inflation in the TIPS
market, which is the difference between a ten-year treasury note and
the ten-year TIP rate, it has only risen from a recent low of 226 bps
on May 1 to 249 bps on June 10. Look at the following chart from Asha
Bangalore of Northern Trust. Note that inflation expectations are not
at recent highs.
The Patient Died Anyway
expected inflation rate of 2.5% is well within "contained." It would be
irresponsible to put the economy into a serious recession under such a
set of circumstances. My Dad had a saying, "The operation was a
success, but the patient died anyway." Raising rates in any serious
manner would whip inflation but would kill the economy at this point.
Rates will need to go back up at some point, but not until the economy
shows signs of a rebound. I think the chances of the Fed raising rates
by the 75 basis points, by January, that the market has priced in, is
What will happen is that over time the annual
comparisons will begin to be less problematic. The cure for high prices
is high prices, as the true cliche goes.
Sadly, we may get some
help on the housing inflation component. Foreclosure filings last month
were up nearly 50% compared with a year earlier. Nationwide, 261,255
homes received at least one foreclosure-related filing in May, up 48
percent from 176,137 in the same month last year and up 7% from April,
foreclosure listing service RealtyTrac Inc. said Friday.
prices of homes in many areas are going to fall to the level at which
they can be rented. As more homes come onto the market for rent, the
pressure on rent prices will fall. And the measure of owners'
equivalent rent will fall along with it. Mark Zandi, chief economist of
Moody's Economy.com (and an adviser to Republican John McCain's
campaign), wrote earlier this week that "the Bush administration's
efforts to encourage loan modifications and delay foreclosures are
being completely overwhelmed."
Separately, a Credit Suisse report
from this spring predicted that 6.5 million loans will fall into
foreclosure over the next five years, reaching more than 8 percent of
all US homes. (AP) That is going to keep pressure on housing prices for
several years at the least.
Thus, it is likely that Bernanke and
company will continue to talk tough on inflation. But, as noted above,
I also doubt that they will raise rates this year, and probably not
until well into the next.
The only reason to raise rates would be
to protect the dollar from a serious collapse. I think it more likely
the Treasury would intervene in the markets to prevent such a collapse.
Dennis Gartman, at dinner Wednesday night, suggested that if the
administration really wanted to get the market's attention, they could
intervene in the currency markets and release oil from the Strategic
Petroleum Reserve at the same time. While it would only be a temporary
fix, it would make speculators nervous. However, they might consider
such an experiment preferable to having the Fed raise rates during the
middle of a slowdown/recession.
And the dollar seems to have
found at least a temporary bottom, and we could see further
strengthening next week, as Ireland voted today to reject the proposed
European central government. Since it takes an absolute 100% consensus
among all member nations, that kills the deal. Europe now has a very
odd shape. They have a commercial union. Some of the members share a
currency. Some of them share actual membership in the EU. Some of them
are in NATO. They have competing and very different needs for monetary
In fact, it will be hard to get anything done in Europe
apart from commercial treaties, etc., as any one country can veto any
particular item which is not to their advantage. Over time, this is
going to be seen by the world as an issue for the euro. And given the
demographic and pension problems of "Old Europe," the currency is going
to come under increased pressure from competing needs for funding,
taxes, and an easy monetary policy.
Six years ago I talked
about the euro rising to $1.50, but I also noted that by the middle of
the next decade it is likely to come back to par. We are halfway on
that journey, and I still think we will arrive at my predicted point.
think it is possible that the dollar could rise 10% or more this year
against the euro, which would help inflationary pressures. Import
prices into the US are up 17.8% year over year. A stronger dollar will
help alleviate that.
Inflation in Asia and Europe
throughout Asia would love to have a 4.2% inflation rate. Indonesia is
at 10.4%, almost twice what they were a year ago. Vietnam would love to
have such mild inflation, as its own level is up over 25%. Inflation in
China is 8%. Inflation is up throughout the continent. And oil and food
are the culprits.
Korea is particularly strained. Korea has seen
its import prices rise by almost 45% in the last 12 months. Read this
note from Stratfor:
"South Korea is among the most vulnerable of
Asia's top economic players to global price increases due to its heavy
reliance on imports for many of life's basic essentials - including
oil, wheat, corn and coarse grains. At least 96 percent to 100 percent
of its annual consumption in each of these items is imported. With
global supplies in these basic necessities set to tighten, South
Korea's inflation and the associated social unrest can only rise.
(Protests in South Korea can draw hundreds of thousands of marchers.)
rate hikes are one of the most readily available tools for fighting
inflation and for propping up a weak currency. In theory, raising rates
would help attract foreign money into South Korea by raising the rate
of return on investments in the country, thus helping to increase the
value of the local currency and to contain rising energy import costs
and inflation. But just June 12, South Korea's central bank decided to
keep interest rates frozen at 5 percent. This was because the potential
economic slow-down an interest rate increase could trigger is too
politically risky for the government, and because there are less
controversial means to bolster the won.
"If interest rates were
raised to tackle the problem of increasingly expensive imports, the
access of Korean businesses and households to credit to fund their
operating costs or mortgage payments would shrink. This would make the
government of President Lee Myung Bak even less popular."
do? Each country will try its own particular witch's brew. China is
raising interest rates, increasing bank reserves, and allowing its
currency to continue to rise. But make no mistake, there are no easy
answers. Each choice has its own unintended consequences.
large part of the problem in Asia is food and energy. And monetary
policy alone cannot address world supply imbalances. To a greater or
lesser degree, every country is faced with the same conundrum. Do you
risk higher unemployment and your economy to fight inflation that is
not strictly speaking a monetary problem? If food is rising 40% in
Vietnam, its workers will have to make more in order to eat? Will such
a price increase force higher wages and perhaps a wage increase spiral
like the US saw in the '70s? If you increase the value of your currency
too fast, you risk losing your competitive price advantage and thus
losing business and jobs.
There Are No Good Solutions
in Europe, I noted last week that one Jean Claude Trichet, the
president of the European Central Bank, virtually promised the markets
a series of rate hikes. This sent the dollar into the tank and the euro
back to new highs. Gold loved it.
But this week has seen a very
unusual set of speeches by fellow ECB members disavowing Trichet's
promise, and even Trichet had to try and "explain" away what he had
said. "We aren't talking about a series of rate hikes. Maybe, just
possibly, we would raise in the event of more inflation." Confusion
reigns. There is clearly not consensus at the ECB.
You can bet
Trichet heard from various finance ministers in the countries whose
economies are weakening. They are not interested in a stronger euro or
higher rates. What one person called the PIGS countries are surely
objecting (Portugal, Italy, Greece and Spain, whose economies are not
And their objections are the same ones that
would be made here. What good would a rate hike do? How much more oil
or corn would be produced? Why increase our pain when there could be no
The central banks of the world got by for years
with easy monetary policies (think Greenspan) because of rising
productivity, cheap energy, increased international trade, a
disinflationary environment because of cheap Asian labor and imports,
etc. Now that economic regime has come to an end. Stability had bred
instability in a very uncomfortable Minsky Moment.
There are no
good solutions. There will only be a choice of how much and what type
of pain. The US, Europe, and Japan are entering Muddle Through World.
The rest of the world is faced with increased volatility. This is a
tough environment in which to be a central banker.
New York, "Chicago," and Wedding Showers
looks like I am going to have to go to New York and Philadelphia the
first week of July for a day of meetings with partners. Larry Kudlow
has asked me to come on his show July 1, and that sounds like fun. And
then I am looking forward to the annual Maine fishing trip hosted by
David Kotok of Cumberland Partners. A lot of good friends will be
there. And I get to go with my youngest son Trey, who always catches
more fish than I do. Maybe this year I can manage to at least stay
Tomorrow is Tiffani's wedding shower, and it looks
like there will be a lot of friends at my home. Her wedding is August
8, and it gets closer every day. There is so much that has to be done.
While I am not doing any of the heavy lifting, I am amazed at how much
the coordination resembles the Normandy invasion.
I will be
speaking at the National Association of Business Economists at the
Dallas Fed this next Wednesday, on the assigned topic of how I use
earnings forecasts in my economic analysis. That portends to be a very
contrarian speech, as long-time readers know my view of the value of
stock analysts and the reliability of their forecasts.
On a very
sad note, I am distressed to learn that Tim Russert passed away. I have
thoroughly enjoyed his analysis and interviews over the years. He has
been like an old friend coming into my home each week, and I will miss
him. Rest in Peace.
On a lighter note, this Sunday evening The
Doobie Brothers and Chicago are in town for a concert, and I am going
to go for a little nostalgic evening. Can you believe it has been
almost 40 years? Where has the time gone?
Let me say thanks to
Pierre and Guy Casgraine, who hosted your humble analyst, Martin Barnes
and Dennis Gartman, and a few friends in Montreal on Wednesday. It was
an exceptionally fine evening. I so enjoy good food and wine and great
friends and conversation. It is one of the true pleasures of life.
your week, as I know I will. And look for a major announcement from me
this Tuesday, as Tiffani and I need your help on a new project. (No,
not the wedding!)
Your getting ready to be an old rocker for a weekend analyst,
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