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A Return to the 1970s?
By Charles R. Morris
The Washington Independent
Thursday 08 May 2008
How the Fed's high-wire bank rescues increase
inflation risks.
The press release announcing the Federal Reserve Bank's latest interest rate
reduction on April 30 had the ominous sentence, "uncertainty about the
inflation outlook remains high." That is an unusual warning in a period
of anemic growth. For anyone who can remember back 30 years, it stirs deep-seated
fears.
Inflation is usually a by-product of overly ebullient markets. The absurd run-up
in house prices during the first half of the 2000s is a classic example of an
inflationary bubble. But there have been times when loose monetary policy overflowed
into rapid price inflation even as the economy was slipping. The most notorious
case is the devastating 1970s period of "stagflation,"' when consumer
prices jumped by double-digit rates amid a nasty recession.
The visible rise in inflation in the wake of the Fed's aggressive monetary
easing is stirring nightmares of a return to the 1970s stagflation hell. The
broad money supply expanded by a 12.6 percent annual rate in the first quarter.
The March-to-March growth in the consumer price index was 4 percent, and an
uncomfortable 2.4 percent, even after excluding food and energy costs. That's
hardly stagflation territory, but still well above the Fed's comfort zone.
There is, in fact, little question that the Fed's high-wire bank rescues have
increased inflation risks. But the mechanisms are complicated and require some
untangling.
For years, America's biggest export has been the dollars it sends overseas
to buy real goods and services - more than $700 billion, net, in 2007,
only modestly down from the all-time record the previous year. The huge buildup
of dollars in foreign hands pushes down the value of the dollar in currency
markets, and drives global price increases in dollar-denominated goods like
oil.
More subtly, the build-up of dollars fuels inflation in states, like most of
the Asian exporters and most of the Gulf states, that try to keep their currency
value "pegged to the dollar. When Washington lowers interest rates, they
are forced to do the same; otherwise their higher local interest rates would
attract currency traders and push up their exchange rates relative to the dollar.
America's second biggest export after dollars, in short, is local inflation.
The best defense against imported dollar inflation is to let the local exchange
rate rise to its economic level. Countries resist doing so for a variety of
reasons. China isn't yet ready to disrupt its U.S. trade bonanza, while the
Saudis fear being left on their own to deal with fractious local Shiites. But
even the steadfast Chinese are showing signs of cracking. Some Chinese goods
are being priced in euros rather than dollars, while cost inflation at home
is starting to work its way into Chinese export prices. Having sent its inflation
abroad for so long, the United States is now importing some of it back.
The devastating run-up in oil prices is partly the result of a real shift in
demand, as consumers in newly wealthy markets like China and India discover
the joys of driving. But it is also, substantially, a monetary phenomenon. The
president of the Organization of Petroleum Exporting Countries recently said
that a 1 percent fall in the dollar works through as a $4 rise in the price
of a barrel of oil.
But subtler unintended consequences of the Fed's monetary easing are also driving
oil markets. Oil companies normally sell futures - in which buyers contract
to take oil at a specific price at a future date - to stabilize revenue
streams. Since futures buyers are protecting oil companies against price drops,
they usually get contract prices somewhat lower than current-market or 'spot'
prices.
Over the last few years, however, Wall Street has been advising their wealthy
clients to diversify their holdings into commodities, especially oil. Speculative
oil futures buying by outsiders has pushed futures prices higher than the spot
markets - an unusual position called "contango." With high futures
prices and low interest rates, it now makes sense for speculators to sell oil
futures and lock in their profit by buying the oil now and storing it for future
delivery. As a consequence, the rapid run-up in crude oil prices has been accompanied
by increases in inventories, which is very unusual. Interest rate-driven oil
speculation, in short, is making the oil squeeze worse (pdf).
The price of grain, the world's most important food staple, has been rising
at about the same clip as oil prices. It's hard to blame the grain price run-up
on the Fed, since it seems mostly a reflection of real supply constraints. The
same emerging market consumers that are buying cars are shifting to richer,
meat-based diets that require far larger grain inputs.
But the nutty U.S. corn-based ethanol program is a big contributor too -
despite the farm lobby's insistence to the contrary. (Corn-based ethanol offers
little or no advantage in energy and climate terms over gasoline.) The World
Bank points out that from 2004 through 2007, global maize (corn) production
increased by 51 million tons, but virtually all of it - 50 million tons
- went to the U.S. ethanol program. All other maize consumption rose by
33 million tons, causing a drop of about 30 million tons in global stocks. More
unintended consequences (pdf).
The biggest difference between the 1970s and the current price run-up is that
workers aren't getting any of the inflationary upside. In those benighted days,
workers usually had cost-of-living escalators, so their pay kept pace with expenses.
Now, worker productivity is rising, but hours worked and real incomes are falling.
For Wall Street, that's the ideal inflation firewall.
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Charles R. Morris, a lawyer and former banker, is the author of "The
Trillion Dollar Meltdown: Easy Money, High Rollers and the Great Credit Crash."
His other books include "The Tycoons: How Andrew Carnegie, John D. Rockefeller,
Jay Gould and J.P. Morgan Invented the American Supereconomy" and "Money,
Greed, and Risk: Why Financial Crises and Crashes Happen."
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