Wednesday, April 16, 2008

Head in the sand inflation

There are those who continue to believe in the days of low volatility and interest rates and easy money, and who wouldn't after all the fun some folks had with that?

For instance, after PPI figures came out today, this chap said,
We all understand the effect of higher food and energy prices not only on the United States but all over the world, so I think what we should really look at is the core prices, which according to the Fed's minutes should be anchored with slowing economic growth and it wont be a problem for the economy giving the fed a freehand to cut rates with no worries that inflation will create a hitch in the future.
But as Barry Ritholtz, who has been banging the table over the fallacy of core inflation for yonks, noted, there is growing realization that commodity price push inflation is a serious economic and political issue to be dealt with, not swept aside or ignored.

Channelnewsasia puts it this way:
While the world has been focusing on the credit crunch at the international investment banks, the fall out from sub-prime mortgage lending crisis and the turmoil in the international markets, another threat to world's economic stability has been gathering pace.

Inflation is the latest genie to escape from the global economic bottle.
The PPI scorecard today was, as reported by Forbes:
Core inflation rose 0.2 pct for the month, after rising 0.5 pct in February. That left core inflation up 2.7 pct in the past twelve months, the fastest unadjusted annual pace since July 2005. Overall inflation has risen an unadjusted 6.9 pct for the year.
In times past that "overall" rate would have been a headline screamer, but the head in the sand crowd continues to crow about the core, even as that is beginning to become "uncomfortable".

And as uncomfortable as the US inflation picture is, the Channelnewsasia story adds an emerging market and wider world-view perspective:
Compared to price rises in Asia, US inflation is quite tame.

Rice prices rose 50 per cent in two weeks at the beginning of April....

Curbing inflation is usually the central bank's biggest task and the best way to do this is to slow the economy by raising interest rates. But with the slowdown in housing and credit crunch in central banks, notably in the US, it has been cutting rates to encourage the banks to lend again.

Lower interest rates are also having a knock on effect of commodity prices.

Cheaper money that is not going into the US housing market or stocks or bonds is going into tradeable commodities.
Actually, that perspective is not so foreign as it may seem. It tracks precisely the arguments made by Ronald Reagan's main Econ Man and Harvard professor, Martin Feldstein, in the WSJ today:
Many factors have contributed to the recent rise in the prices of oil and food, especially the increased demand from China, India and other rapidly growing countries. Lower interest rates also add to the upward pressure on these commodity prices – by making it less costly for commodity investors and commodity speculators to hold larger inventories of oil and food grains.
Feldstein's remedy is: enough with the interest cuts, already.
It's time for the Federal Reserve to stop reducing the federal funds rate, because the likely benefit is small compared to the potential damage.

Lower interest rates could raise the already high prices of energy and food, which are already triggering riots in developing countries.

The impact of low interest rates on commodity-price inflation is different from the traditional inflationary effect of easy money.

Lower interest rates induce investors to add commodities to their portfolios. When rates are low, portfolio investors will bid up the prices of oil and other commodities to levels at which the expected future returns are in line with the lower rates.

An interest rate-induced rise in the price of oil also contributes indirectly to higher prices of food grains. It does so by making it profitable for farmers to devote more farm land to growing corn for ethanol. The resulting reduction in acreage devoted to producing food crops causes the supply of those commodities to decline and their prices to rise.

Rising food and energy prices can contribute significantly to the inflation rate and the cost of living in the U.S. The 25% weight of food and energy in the U.S. consumer price index means that a 10% rise in the prices of food and energy adds 2.5% to the overall price level. Commodity price inflation is of particular concern now that the CPI has increased 4% in the past 12 months.

The rise in the U.S. inflation rate, and the adverse effects in emerging market countries, might be defensible if lower interest rates could significantly stimulate demand and reduce the risk of a deep recession. But under current conditions, reducing the federal funds interest rate from the current 2.25% by 50 or 75 basis points is not likely to do much to stimulate demand.

The current conditions in the housing industry and in credit markets mean that a further lowering of interest rates will have a smaller impact on demand than in previous recessions.

Moreover, lowering the fed funds rate has not brought down mortgage interest rates. While the fed funds rate is down three percentage points from this time last year, mortgage interest rates are down by less than 0.5 percentage points.

The dysfunctional state of the credit market means that many individuals and businesses are unable to get credit. Lowering interest rates will not stimulate demand for those who cannot get credit.

Economic recovery will require resolving the difficult problems of the credit markets, dealing with the millions of homeowners who may now be tempted to default on mortgages that exceed the value of their homes, and reducing the risk that the ongoing decline in house prices will push millions of additional homeowners into a vulnerable, negative equity condition. A lower fed funds rate will not solve any of those problems.

Down Under, Australian Treasure Wayne Swan discussed the inflation implications for his economy, as reported in the SMH:
"The other thing that has jumped out of the box is inflation, not just in developed world but in the developing world, in the years ahead," he said.

Until now, cheap imports from countries such as China have had a deflationary impact on the Australian economy, he explained. But with inflation on the rise in the economies of our major trading partners, there would be a new external source of pressure on inflation - rising import prices.

"We have a high inflation environment and a high interest rate environment in a context where both growth is slowing and inflation rising, so it is a much more complex international environment than we have seen in a long time."
The Australian Murdoch press, though, is barracking for no more interest rate rises in Oz, which may be fair cop given that the Australian Reserve Bank has been raising rates lately even whilst the US Fed has been slashing. The Australian's mouthpiece, Peter Switzer's take is: "The next move should be down."

But he doesn't say when.



FOLLOW UP:

The Fed's inflation gauge isn't realistic, critics say

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