By Philip Brewer
For a decade, starting in the mid-1990s, the Federal Reserve kept interest rates too low and expanded the money supply too swiftly. Their theory was that, as long as consumer prices were stable, they must not be creating too much money. We now know that they were wrong.
Confused by the way globalization held down consumer prices, the Fed printed us up a metric truckload of inflation. It showed up in house prices, stock prices, oil prices, grain prices–pretty much all prices except the prices of stuff made in low-wage countries and imported into the United Says. Unfortunately, those prices are a major component of the CPI–and particularly of the “core” CPI (consumer prices excluding food and energy).
Starting in late 2006 and accelerating in late 2007, though, that inflation started spilling into consumer prices as well.
The US (both the government and individuals) had borrowed huge amounts of money. Between that and the rising inflation, holders of dollars were beginning to think that maybe they didn't want all their cash in dollars. That put downward pressure on the value of the dollar, which pushed up the prices of just about everything (because the US imports just about everything). Prices soared–oil, wheat, milk, corn, anything traded globally got more expensive: This was a decade of excessive money creation by the Fed finally showing up in prices.
Just as this was happening, though, the Federal Reserve seemed to lose its mind. Instead of raising interest rates to curb inflation, it started cutting rates. Pointing to the “core” rate of inflation, which barely budged, the Fed suggested that deflation was a larger worry than inflation.
The verdict is still out on that, but there's some new evidence that the Fed is right.
First, prices of global commodities are falling. In just the past few months:
So, what's going on? There are lots of forces at work, and they're currently feeding back into one another.
US as a safe haven
The same people who had decided that, in view of the US trade deficit and budget deficit, they didn't want to hold so many dollars have changed their tune. If the economy is going to melt down, maybe the US isn't such a bad place to have some wealth. The US has a strong tradition of sound banks and other financial institutions. In addition, it has seemed much more willing these past few weeks to take aggressive action to protect its financial system than some other countries.
With more demand for the dollar, it has been rising against foreign currencies. A stronger dollar means lower dollar prices for global commodities.
Leverage
During the big spike in commodities, many investors piled on, trying to make money on what was obviously a long-term upward trend. Many of them did so with borrowed money–and many thought that the dollar would be the cheapest currency to borrow, because dollar interest rates were low and the dollar was falling.
Now, with the dollar rising, many of those investors are moving to unwind those transactions–selling their commodities so they can pay off their dollar debts now, before the dollar moves even higher. That pushes commodities down and the dollar up.
Economic slowdown
Less business activity means less demand for basic commodities, leading directly to lower prices.
Producers of basic commodities will obviously see lower profits. Other businesses are facing lower profits as well, even though some of their inputs are shaping up to be cheaper, simply because of falling demand due to the general economic slowdown.
Notice that these forces emphasize one another–any sort of economic stress makes the safe-haven aspect of the US look more attractive, anything that makes the US look more attractive raises the value of the dollar, and a higher dollar pushes down the price of commodities, producing more economic stress, and so on.
What about inflation?
Just as higher commodity prices looked like inflation, lower commodity prices look like deflation.
I think there's a long-term trend toward higher commodity prices, simply because rising demand inevitably runs up against limited resources–oil, fresh water, arable land, etc. Because of that, I think declines in commodity prices are going to be temporary. Even so, prices might stay down for a considerable period, if the economy remains stressed for a considerable period.
I was one of those who, a few months ago, thought the Fed had lost its mind. Slicing interest rates just as inflation was spiking up to generational highs seemed like exactly the wrong policy. I've changed my mind. I certainly don't know if the Fed's policy is the right one, but I no longer think it's an insane one.
Vast amounts of “money” have simply disappeared: the illusionary wealth of the housing bubble, the mortgage-backed securities based on it, and the paper assets based on those. The destruction of that “money” is hugely deflationary. The Fed is trying to create enough money to offset that destruction. The problem is that they’ve no way to know how much money to create. They're walking a tightrope, with a deflationary depression on one side and hyperinflation on the other.
The Fed is clearly inclined to err on the side of inflation, simply because they know how to cure inflation. Only astounding luck would produce a soft landing at this point. The Fed is aiming to produce a modest amount of inflation–confident that, if it manages that, it can bring the inflation back down once the economy is out of danger. In the short term, though, I think the danger of inflation has fallen quite a bit, simply because so many people want to hold dollars.
Since the Fed is trying to create some inflation, I don't expect this situation to persist for long–I wouldn't get rid of your inflation hedges–but don't enter into transactions anticipating inflation to bail you out, and don't be surprised if we see some of the price hikes of the past few months suddenly reversed.
It's a scary situation, and it's not very comforting to realize that the central bankers are just as scared as we are.
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