The Trend Towards Higher Inflation

Inflation - a political imperative in the US

By allowing debts to be repaid in depreciated currency, inflation favours debtors at the expense of creditors. Also, inflation often has the effect of boosting asset prices, thus increasing the collateral that supports existing debts and providing the basis for new debts. A problem inevitably arises, however, because creditors aren't stupid - they don't like to see their real returns dwindle as a result of loans being repaid with depreciated money. They therefore begin to adjust interest rates higher to account for the currency's anticipated loss of purchasing power over the period of the loan.

The US has experienced a high inflation rate over the past few years. However, as discussed many times in the past, the strong Dollar has suppressed the negative effects of the inflation. By helping to keep producer and consumer prices in check, the rising trend in the Dollar's foreign exchange value has alleviated the need for the high market interest rates that would normally result from high inflation. With the Dollar's foreign exchange value no longer trending skyward, a substantial rise in long-term market interest rates is now on the cards.

American voters are up to their eyeballs in debt, so higher market interest rates and the knock-on effects of higher interest rates (less spending, less investment, lower growth, higher unemployment) would cause big problems to say the least. The potential solutions? Allow the economy to experience a severe multi-year recession to wash away the excesses, thus guaranteeing a loss for the incumbents at the next election, or inflate at an even faster pace to postpone the day of reckoning (hopefully, to some time after the next election). Clearly, the political pressure on the Fed to keep inflating will be enormous.

The big question is, if deflationary forces take hold can the Fed keep the money supply expanding? The answer is no, not if it sticks to its routine of simply setting a target Fed Funds Rate. As the Japanese have shown, even taking interest rates all the way down to zero is of no benefit if lenders stop lending and borrowers stop borrowing. However, the Fed's power is not limited to the setting of a Fed Funds Rate target. In fact, as the following passage from Bob Woodward's book "Maestro" clearly shows (the passage deals with the tactics contemplated by the Fed in the wake of the 1987 stock market crash), the Fed's power to create money out of nothing is effectively unlimited: 

"They [the Fed] had the legal power to buy up the entire national and private debt, theoretically infusing the system with billions, even trillions, of dollars, more than would ever be necessary to restore liquidity and credit. Of course, the result of that would be Latin American-style inflation. 

In addition, there was an ambiguous provision in Section 13 of the Federal Reserve Act, the lawyers told Greenspan, that could allow the Fed, with the agreement of five out of seven members of its board, to loan to institutions - brokerage houses and the like - other than banks. Greenspan was prepared to go further over the line. The Fed might loan money, but only if those institutions agreed to do what the Fed wanted them to do. He was prepared to make deals. It wasn't legal, but he was willing to do it, if necessary. There was that much at stake. At that moment, his job was to do almost anything to keep the system righted, even the previously inconceivable."

If at some future time the Fed does make full use of the money-creating powers available to it then the power of the Dollar (purchasing power, that is) will plummet. However, a reduction in the Dollar's purchasing power will always be tomorrow's problem until it gets completely out of control, at which point it will become today's problem. Until the depreciating Dollar does become today's problem, that is, until soaring interest rates make it today's problem, there is no reason to expect the US monetary authorities to do anything other than inflate. 

Anticipating tomorrow's headlines

It is easy to get caught up in the news of the day when all we read/hear is that commodity prices are tumbling, inflation is nowhere to be seen and central banks must keep cutting interest rates to avoid deflation. However, when we step back and take a broad view of the financial markets and of the leading indicators that give us clues as to what tomorrow's headlines are going to be, a different picture emerges.

What we see is that long-term interest rates bottomed in October of 1998 and made a higher low in March of 2001. 

We see that commodity prices bottomed during the first half of 1999 and appear to be in the process of completing a normal (Wave 2) correction. 

We see that the gold price bottomed in August of 1999 and completed a normal (Wave 2) correction earlier this year. 

In general terms, the financial markets are whispering the message that we are in the very early stages of an inflationary cycle. That message is, at the moment, barely audible over the deflationary noise, but it will get louder over the next 12 months.

Of course, what we are going to see over the next 12 months as commodity prices complete their corrective moves and turn higher is not inflation, but the effects of the inflation (the increase in the money supply) that has already occurred. Over the past few years the effects of the rampant inflation that has been going on in the US have been muffled by the upward trend in the Dollar's foreign exchange value, but that protective shield is in the process of disappearing.

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