Fed More Interested In Deflation Than Inflation

Bill Bonner - Fri 09 May, 2008

We guessed the Fed would be more interested fighting deflation than booming inflation.

The markets didn’t reveal anything very telling yesterday. The Dow rose 52 points. The dollar held steady. Oil remained near its all time record of $123. And gold went up $10.

So far, things have worked out more or less as we expected. The “war” between inflation and deflation has produced plenty of noise and casualties…but no decisive victory.

We guessed that the Fed would be far more interested in fighting a deflationary recession than in fighting an inflationary boom. America’s central bankers see their mission in three parts – to protect the value of the dollar…to protect the banks…and finally to make sure that all politicians are re-elected and all Fed governors are reappointed. This last part of their mission leads them to ignore the first part. In order to help the career prospects of politicians and their Fed appointees, the latter must try to keep the economy moving forward – even to its own destruction. In the present context, that means holding off badly needed corrections. Consumers, government and business are all deep in debt. But none of them are going to cut back on spending unless they have to. A correction would force the issue; so, it is to be avoided at all costs. And the most direct and immediate cost is what is supposed to be the Fed’s number one priority…the US dollar.

We guessed that inflation would push up commodity, oil, gold and consumer prices…more than it would help the real economy and stock prices. That seems to have happened too. Commodities, oil and gold have all soared. The economy, meanwhile, is growing more slowly than the population. And stocks rallied and retreated – and ended up about where they were 10 years ago.

But what about the kind of inflation people worry about? What about consumer price inflation? How come consumer prices have not gone up more?

Give it time…dear reader…give it time.

This week, both the Bank of England (BOE) and the European Central Bank (ECB) decided that it was more important to fight inflation than it was to try to boost economic activity. Both left their key lending rates where they have been – at 5% for England, 4% for Europe - or two to two and a half times the Fed’s rate. Naturally, each of the seven rate cuts in the US made the US dollar less attractive; who wants to hold a deposit in dollars paying 2% when he can shift his money to euros and earn twice as much?

Speculators saw the trend coming and sold the dollar down below $1.60 per euro – and sent gold over $1,000. Then, they saw what looked like the end of the line for this trend too. The Fed only has 200 basis points left. And it has warned that there may not be any more cuts coming soon. The dollar strengthened. Currently, it is at $1.53 per euro. Gold also retreated…and yesterday stood at $882

Meanwhile, Jean-Claude Trichet, head of the ECB warns that we may be in for a “rather protracted period of high inflation.” The BOE also says it has to try to keep a lid on inflation. The Daily Mail came out with one of its shocker stories two days ago; saying inflation had so raised the cost of necessities in Britain that the average household now has less discretionary spending money than it had 17 years ago. In effect, the typical family is poorer than it was in 1991.

We have not seen comparable numbers for the US, but we suspect they will show the same thing: that by the time a family has finished paying for food, fuel and medical care it has less money left over than it had before Bill Clinton’s first term. Why? Because inflation is doing its work – it is reducing Americans’ real wealth.

But so far, it has come in like a black cat at midnight…on paws so silent hardly anyone has noticed. The US government even claims it is not there at all. “Core” inflation is still under control, say the feds.

What was amazing about the last 20 years was that the dollar-based monetary system worked as well as it did. You would have thought – and we did think – that once the link with gold was severed in 1971, there would be no stopping inflation. Instead, inflation went down…to levels that hadn’t been seen since Eisenhower. Why? Because there were so many things holding consumer prices down – 2 billion new workers in the labour pool, Wal-Mart’s Everyday Low Prices, just-in-time inventory systems, computers, globalisation, deregulation, and the rise of modern capitalism worldwide. But now, the benefits from those trends seem to have reached their limits.

Labour rates are going up rapidly in China and India. Commodities are soaring…governments are re-regulating…modern capitalism has been weakened by its own excesses…and inventories are at 40-year lows.

Inflation – like everything else in the financial markets – has been globalised. And soon, inflation will come in – not as a little kitty, but as a mean panther…

*** When the Roman Empire was still young and vigorous, work crews and engineers followed the legions. Wherever the armies conquered, roads, bridges and water systems were built. Some of them were so well constructed that they are still in standing.

But then, we are a ‘deathward going tribe’ – as Aristotle put it – no matter what flag we fly. Pretty soon, the Romans reached their limit…then, roads fell into disrepair…and armies could no longer manoeuvre quite as well as they used to. As the infrastructure goes, so goes the empire. Finally, the empire fell…and vines grew over the Capitoline Hill.

How’s the infrastructure in the US? A reporter from the Financial Times gives us an update:

“On the pot-holed highway to hell,” to he calls it.

“If anyone doubts the problems of US infrastructure, I suggest he or she take a flight to John F. Kennedy airport (braving the landing delay), ride a taxi on the pot-holed and congested Brooklyn-Queens Expressway and try to make a mobile phone call en route.

“That should settle it, particularly for those who have experienced smooth flights, train rides and road travel, and speedy communications networks in, say, Beijing, Paris or Abu Dhabi recently. The gulf in public and private infrastructure is, to put it mildly, alarming for US competitiveness.

“You might have expected that investing in US infrastructure would be a hot political topic this year. Well, no. Hillary Clinton spent the final week of her Indiana campaign standing on the back of a pick-up truck arguing for a temporary suspension of the "gas tax", the fuel duty that pays for highways.

“You read correctly. Faced with the emptying of the Highway Trust Fund, established in 1956 as the US entered a period of growth and prosperity, Mrs Clinton suggested cutting its source of funds (which she claimed could be made up by a tax on oil companies). It was more important to give Americans a summer break from $4-per-gallon petrol.

“The US invested 10 per cent of its federal non-military budget in infrastructure in the 1950s and 1960s as it built the interstate highway system - at the time, the envy of the world. While US investment has fallen to less than 1 per cent of gross domestic product, China has been matching its double-digit post-war record.”