Investors Pray for Inflation

When an unexpected outage on the north slope of Alaska can drive crude oil prices to nearly $78/barrel - you know the world is awash in dollars. The effects of a dollar glut are seen in Lebanon where Hezbollah has fielded a sophisticated light infantry force capable of inflicting painful fatalities on Israel's army, while still maintaining its terror blitz of missiles - all supplied by Iran's oil money.

In this environment, investors are betting that Ben Bernanke will prove to be soft on inflation. After all corporate profits are growing at double digit rates, they aren't paying the inflation tax, or the stagnation tax.

It sets the stage for the first decisive moment of Bernanke's tenure.

While all political junkies are looking to Connecticut, where challenger Ned Lamont holds a slender lead over Joe Lieberman - the Lamont campaign never believed the more optimistic polls, and has been mounting a 24x7 call for help in getting the vote out, even as Lieberman has pulled resources out of his GOTV operation - the world of money is concerned about a different number - namely, the decision by Ben Bernanke and the Federal Reserve on interest rates this week.

To tell the story: the Federal Reserve is the US central bank, it sets how easy it is, and how cheap it is, for banks to lend money, it is by lending money that banks create money, and the money supply increases. Thus the Federal Reserve's impact on the economy is indirect, and takes time to act. This is the trade off - fiscal stimulus can work quickly, but some of it is eaten up by inefficiencies - monetary stimulus works slowly, but reaches a more efficient equilibrium. Well, that's the theory any way, but what I know is America under a guy from Texas, and out here, you on yo own.

The reality is that that the Federal Reserve makes the economy do more of whatever it is wanted to do. If the barrier to productivity is simply lack of money, or the cause of inflation is simply an excess of it, the Federal Reserve is very good at either increasing economic activity or damping down inflation. However, if the problem is that the economy has made poor decisions on aggregate - particularly the largest single player in the economy, the Federal Government - then the Federal Reserve can mask, but not remove, structural problems.

But investors, particularly large investors, don't really care about the long term health of the economy, they care about what they pay for money, and what they get back when they invest. Since 1999, US equities have been essentially flat in real terms - and there is very little that investors can do about this, except exercise shareholder activism and change management. But it isn't clear that there is better management waiting in the wings, and most shareholders, locked in side pension funds and mutual funds, can't vote anyway. Most shareholder activism comes from private equity firms, hedge funds, and very large investors who can make the splash of a hippo off a diving board.

Thus, like most people who can't change what the private sector is doing, investors turn to the government, and hope that it will make their lives easier. Those who can, do, those who can't, lobby.

When, in the face of deflation and a federal stimulus package which was ineptly designed and wastefully executed, the Federal Reserve set its policy to "accomodative" and dropped its benchmark rate to 1% - it helped touch off a secondary bubble in housing. In retrospect economists realize this. Some of us were saying "secondary bubble" as early as 2002 - predicting that housing would be used to offset the effects of a stock market crash. There have been many examples of secondary bubbles, including one in the early 20th century which was the ultimate stimulus for the Income Tax amendment and the Federal Reserve itself.

The Fed took the economy into uncharted territory - and along with the Bank of Japan's zero interest rate policy - the BoJ was, in effect, giving money away - it created a huge flood of hard currency which has driven up commodity prices, stock prices and housing prices, not just in the US.

Then the Fed changed course, and began, in very tiny baby steps, to raise interest rates - but one quarter of one percentage point - that is "25 basis points" in econ-speak where a "basis point" is .01% - at each of 17 consecutive meetings. This foot dragging rate of increase was driven by a desire to produce what is known in economics as "a soft landing". A soft landing is when the economy nearly slows to a stop, but doesn't quite, and this slowing is enough to reduce inflationary pressures. In economic history soft landings are rare. The close cousin of the soft landing is the hard landing - an example of this being 1986, when unemployment went up, GDP fell for the total year, but the decline was never sustained enough, or broad enough, to quite drive the economy into recession. The reverberations of that hard landing caused the 1987 stock market crash, touched off the Japanese "Bright Depression" of 1988-2004, and the Savings and Loan Bail out, the most expensive bank bail out in the history of mankind.

This historical reality, however, is not the most important factor which has Bernanke caught in a riptide. the US is out of step with the BoE's assessment of monetary conditions - and even observers who are very friendly to Bernanke's argument that the US economy is going to slow enough to squeeze out the inflation that the Fed cares about - wage inflation - are calling for a firm move on the part of the Fed to renew its inflation fighting credentials. This is because one of the drivers of inflation is believed to be inflationary expectations. People begin buying now rather than buying later, out of the fear that later prices will have risen.

Adding to the pressure to raise rates - aside from inflation that, if it is not out of control, is certainly out of hand - is another factor. Persistent high budget deficits - pay no attention to the headline Federal Budget Deficit, because that number only exists in the never never land where the US isn't involved in Iraq, because war costs are off budget - means that the US must keep issuing bonds. Until recently when one could borrow money from the BoJ for nothing, buy US bonds and make a profit on the world's ultimate carry trade, central banks and others were willing to hold dollars. For over a year and a half, these same big investors have been unwinding their bond positions, and it has gotten to a worrisome pace.

So, on one hand, inflation data, oil prices, federal borrowing and the dollar dump are pressuring Bernanke to continue raising until the corner on inflation and the fed has offset the stimulus from federal deficit spending. This would make a rate raise a sure thing if let to itself - since 2.5% GDP growth would normally mean that there was plenty of room for a more restrictive monetary policy.

However, there is another hand, and that is that is the political reality that the present government regime is wildly unpopular - just touching 40% approval in the best polls, and having spent virtually the entirety of 2006 wallowing in the 30's. While the US has been growing rapidly, all of that growth has gone into corporate profits. Real wages are falling. There is also the glaring problem that while housing, which has driven private employment in the US, is cooling - business spending, sitting on large mountains of cash though many US companies are, has not picked up.

Here Bernanke is caught in the tax trap. Everyone knows that current US tax rates are unsustainably low. Hence companies have every incentive to profitize everything they can, but no incentive to spend, since this will not decrease their tax burden by as much. Instead better to hold and buy back shares or hand out dividends, which make executives and big shareholders happy, but don't generate much in the way of employment. Thus business are clamouring for the free ride to continue, inflation be damned, while tax rates are low.

And the markets expect to get their way - the futures market, which bets on which way rates are going to go - thinks there is less than a 20% chance that Bernanke will raise, and no raise is priced into US stocks. The last thing that a partisan Fed chief wants is a stock market tumble before an election. And he has some cover - recession worries are now sprouting like overnight mushrooms. Bernanke can argue that the risks in the economy are now tilted to stagnation more than recession.

Even though the inflation is here, and the recession is not.

Objectively speaking what this economy needs is a good tax increase, so that the Federal government could put money back to work - in say rebuilding Katrina, converting the US energy infrastructure, bailing out a trouble pension system before it becomes catastrophically unravelled and converting to single payer healt care - but the reality is that Bush isn't competent to rebuild a Iraq, let alone the US.

However, the Fed has no real influence over fiscal policy - even if Greenspan from time to time proved that he might have been the best central banker in history, he was clearly one of the worst senators by pushing for budget busting revenue reductions - and must make its decisions, not based on what the Federal government ought to be doing - pursuing fiscal sanity - but on what it is likely to do. While there have been noises out of Washington that it will slash benefits, medicare and other programs that help ordinary people, the Fed has heard this before from Bush - in 2004 when Social Security Privatization was supposed to be the top priority for the second term.

The reality that Bernanke and the other Fed governors have to face is that Bush is no more capable of making tough decisions than the central bank has been, and the rest of the world will believe that the Gop has relearned the joys of austerity when they see concrete signs. After all, with a working majority in both houses of Congress, a friendly supreme court and control of the Presidency backed by a media that has been willing to lie to cover up mistakes, blunders and crimes - what better environment for taking big steps to end the New Deal will there be? If a powerful war time President can't alter the direction of the government, no one can.

For those of us who have been critical of Ben Bernanke - and I warned people in 2001 that he was the next Fed chief and that he was a conservative inflationist - this meeting is his last chance to prove us wrong - a 50 basis point increase in the discount rate and overnight rate, coupled with other tightening moves such as increasing reserve requirements and using the Federal Reserve's moral authority to announce that inflation must remain dead - would quiet critics. However, the overwhelming likelihood is that the party in power, like all parties in power that have run out of ideas and run out of political courage and political capital - is going to favor the inflation tax that is falling on people who don't vote for them, over a recession which will also afflict people who do vote for them.

The ball is, however, in Ben's court.

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