The Fed Plays With Fire
Written by Jeff Thredgold, President, Thredgold Economic Associates
“It’s hard to get the toothpaste back in the tube when it’s already out”
U.S. and global inflation pressures are on the rise. This is not to say that rampant U.S. inflation reminiscent of the late ‘70s/early ‘80s is upon us…nothing of the kind. However, prices are going higher.
The Consumer Price Index (CPI) rose 0.4% during each of the past two months, the largest consecutive monthly gains in two years. The CPI has now risen 1.6% during the most recent 12-month period, with modestly higher inflation likely during 2011 and 2012.
Rising commodity prices for…well, most everything…are now occurring. Higher prices are found for oil, steel, copper, silver, cotton, coffee, most agricultural commodities, etc. Many American companies are now in a process of boosting prices modestly at the retail level to compensate for their own higher raw material prices.
“Having a little inflation is like being a little pregnant…” Dian Cohen
Ironically, a slightly higher level of inflation has been a goal of the Federal Reserve during the past two years. I guarantee you that the Fed has been more concerned about prospects for deflation than inflation since 2009.
History tells us that dealing with deflation—declining prices, followed by declining incomes—is a more difficult challenge than is dealing with inflation…just ask the Japanese. The Fed made a conscious decision not to go there.
The Federal Reserve is on record as to the desirability of inflation running 1.5%-2.0% annually. Such a level allows for both modest price increases and modest wage increases. The challenge is not letting inflation pressures escalate from there.
“Inflation is when you pay fifteen dollars for the ten-dollar haircut you used to get for five dollars when you had hair.” Sam Ewing
One major factor will make life very challenging for the Fed during the next 2-3 years. The Fed’s most important interest rate, the federal funds rate, has been at an all-time low target level of 0.00%-0.25% for the past 26 months. In addition, the Fed’s two programs to purchase roughly $2,000,000,000,000 in U.S. mortgage-backed securities and U.S. Treasury notes, affectionately known as QE1 and QE2, have provided even more monetary stimulus (more toothpaste).
At some point, perhaps a year from now (if not slightly sooner), the Fed will face greater inflation anxiety and will need to unwind the unprecedented monetary stimulus now in play. Such moves will be largely welcome by financial market players, who have a real distaste for inflation.
However, how will members of the U.S. Congress react, particularly in light of a still high level of unemployment at that time? The Fed is, after all, a creation of the Congress.
Rising Global Inflation
Inflation pressures are higher around the globe than within the U.S. Chinese prices are 4.9% higher than a year ago, while food and most energy prices have risen sharply in dozens of lesser developed nations.
One contributor to higher global and domestic inflation is strong economic growth. Stronger growth leads to rising demand for basic commodities and materials, leading to rising prices.
Keeping the lid on inflation will be a major task for the Fed…
U.S. consumer confidence rose to the highest level in three years in February, one more positive sign for economic growth prospects. Unfortunately, the latest laundry list (say that three times quickly) of headwinds is likely to dampen the good news.
The Conference Board noted its Consumer Confidence Index jumped to 70.4 in February, up sharply from January’s 64.8 reading. The accompanying statement noted the rise was “due to growing optimism about the short-term future.”
The rise in the Index is good news, no question. Consumer spending accounts for nearly 70% of the overall economy. Before getting too excited, however, note that the Consumer Confidence Index averaged 97.0 in the six years leading up to the Great Recession that began in December 2007 and ended in June 2009 (bloomberg.com).
That confidence is likely to be shaken in coming days and weeks by a series of uncertainties…
Recent political turmoil and violence in the Middle East and Northern Africa has sent oil prices sharply higher, with prospects of even higher prices to come. Worst case fears of oil disruption could easily push oil prices $10-$30 higher per barrel, leading to slower U.S. and global economic growth. Gasoline prices, which averaged $3.14 in recent days across the country, could approach $4.00 again.
Wild forecasts of $5.00 per gallon of gasoline seem, for the moment, highly unlikely. The Saudis have indicated their willingness to largely offset any shocks to oil output of other nations.
Outside Political Change
If given the opportunity, impress upon your kids and/or grandkids the historic changes taking place in the Middle East and Northern Africa today. Note that the events taking place as we speak will be read about in history books by their children.
The hunger for individual freedom and opportunity is powerful…and being played out in bloody streets today. How many of us would be willing to take to those streets, knowing we may be killed in the name of freedom?
Inside Political Change
Coming days will see more political grandstanding and risk taking in the nation’s capital, as a Republican-led House of Representatives battles with a Democrat-led Senate and White House. The issue is what level of spending reductions can be agreed to by both parties…and avoid a government shutdown when current spending authority ends on March 4.
This issue has played out before when a Newt Gingrich-led House battled with President Bill Clinton 15 years ago. A temporary shutdown ultimately strengthened the President’s hand…and weakened that of Gingrich.
This latest battle of wills finds the House wanting $61 billion in cuts from the massive $3.7 trillion budget proposed recently by the President, a reduction of just 1.6%. The projected deficit in the budget? $1,600,000,000,000…the largest ever. The Senate and the Administration want fewer cuts.
Note: U.S. government spending is TWICE what it was just 10 years ago.
Again… U.S. government spending is TWICE what it was just 10 years ago.
This skirmish is actually minor league versus the battle of wills to take place in coming weeks as the debt ceiling must be raised. Republicans must push for more, including slowing the growth rate of entitlement program spending in future years. Bipartisan cooperation is essential.
Without addressing the future of entitlement spending, no realistic chance exists to get our financial house in order. Without such an agreement, it will take a future financial crisis to finally force politicians’ hands…
…we deserve better