Ok, I’m going to attempt to condense my previous post down to a few sentences, so my question is clear enough:

Inflation is too much money chasing too few goods. This causes prices to rise, including that of money, which needs to now include the cost of inflation in the interest rates charged to borrow. In turn then, higher interest rates drive down the prices of the things which normally require financing to purchase, things such as houses and businesses.

Is this a correct analysis? Does this mean that inflation has an inverse effect on the price of land and businesses? Does it therefore make sense to hoard cash, and make a purchase in land or a business knowing that the debt will be refinancable when the inflationary time ends, and that the asset purchased should also rise in value with the decrease in interest rates? What is the proper way to time such an investment? Should one wait until interest rates exceed 10%?

I think I may post this as a question in the LinkedIn forums and see what kind of response I get.

I’ve been thinking about inflation, interest rates, and asset values lately, particularly with respect to how they effect business decisions that need to be made in the coming years. What follows is my attempt to work those out. Please leave your thoughts in the comments, as I make no claim to being right about what I’m about to post; it’s more like online note-taking.

Inflation is often described as “too much money chasing too few goods”. And this is technically correct. Inflation happens when the government introduces money into the system at a rate faster than new wealth is produced, leaving an oversupply of money, causing prices to be bid upwards.

I have long maintained that we are living in an inflationary period, that low interest rates were a major cause of the housing boom, and that the only reason why we didn’t see price appreciation in consumer goods and services was due to the influx of cheap goods from Asia and labor from India (via the Internet) and Mexico.

In fact, it was an incorrect definition of inflation that made the central bankers keep interest rates for so low for so long. Namely, that inflation is “price appreciation” and conversely, that deflation is “price depreciation”. This, of course, is nonsense. Price appreciation or depreciation is a symptom of inflation, but not a necessary indicator of it. In a normal economy, prices should gradually decrease for all manufactured products because technology improves over time. We see this most readily in the computer hardware industry, but it happens in slow motion across all industries. So when central bankers see small amounts of price depreciation (actually fueled by improved technology or new economies coming online) they often take measures to prevent deflation. But those measures involve increasing the money supply, which has to go somewhere, and often winds up creating speculative bubbles.

So far so good. arguably, then, when a bubble pops, you may have a brief period of actual deflation, in that people who had real wealth and invested it would have seen it lost, but on the other side, no small measure of people would have gained real wealth from riding the wave. On the other hand, some number of people would have increased their consumption, feeling that they were rich. Therefore, when the bubble pops, there would have been less wealth around relative to the amount of money representing it. On the other-other hand, in the aftermath of a bubble popping, many would-be investors will hold tight for fear of losing their money again, and this would represent some of the same symptoms as deflation, as it effectively is people hoarding their money.

Regardless, it’s hard to dismiss the combined orgy of government spending and borrowing, while the Fed maintains low interest rates and buys assets that they know to be worthless, all of which injects money into the economy, and not be worried about future inflation. The question is how will it play out and what to do about it?

Now here is where I get really confused. Traditionally, inflation should mean higher asset prices. Which is why holding precious metals or land would make for a good hedge. However, the price of assets, such as land, is inversely impacted by interest rates. And in inflationary times, interest rates will eventually rise to incorporate the rate of inflation. So if in normal times an asset (large enough to require financing) would drop in value when interest rates go up, and be bid up in value when interest rates go down, then how can land make for a good investment in rough economic times? Wouldn’t land actually decrease in price during real inflationary times because financing costs would drive prices down?

We are starting to see something like this in private equity as well, where EBITDA multiples for companies are dropping as the cost of capital rises. So is it that it makes sense to buy during inflationary times, only to refinance when times are better? If that’s the case, then the strategy makes sense to me.

So this would point to a strategy of not paying down existing debt (whether it be in a mortgage of whatnot) so long as the interest rates are reasonable, but investing heavily in hard assets (large enough to require financing to buy)? Then you refinance or even sell when interest rates lower again after the inflationary period comes to a close. But again, that assumes it ever does come to a close.

This would explain why people who bought their houses in the midst of double digit interest rates were able to cash out at multiples of what they paid, all the while they were able to refinance at a lower rate of interest when times were better, and perhaps use the savings to even buy a second house.

So am I missing anything here? This analysis would point toward not purchasing either a company or a house now while interest rates are relatively low, but instead waiting until rates go up, holding tight, and then selling or refinancing when normality returns some years down the road. Timing is everything in this environment. Does anyone have any sense of what one’s timing should be?

UPDATE: Upon rereading this, the prose is dense and confusing. I may try to rewrite the central question posed here in another blog post.

Jim May has written up an excellent analysis of our current economic situation, showing how we’re in an inflationary period, despite what popular economists say. Be sure to read the whole thing.

Caught this over on Drudge [emphasis mine]:

China’s State Reserves Bureau (SRB) has instead been buying copper and other industrial metals over recent months on a scale that appears to go beyond the usual rebuilding of stocks for commercial reasons.

Nobu Su, head of Taiwan’s TMT group, which ships commodities to China, said Beijing is trying to extricate itself from dollar dependency as fast as it can.

Read the whole thing.

George Will has a must read devastating account of the current congress. He goes policy by policy, comparing how even nations many Americans would consider backwards, corrupt or tyrannical have better sense than our government does now. A sample:

Another embarrassing auditor of American misgovernment is China, whose premier has rightly noted the unsustainable trajectory of America’s high-consumption, low-savings economy. He has also decorously but clearly expressed sensible fears that his country’s $1 trillion-plus of dollar-denominated assets might be devalued by America choosing, as banana republics have done, to use inflation for partial repudiation of improvidently incurred debts.

Be sure to read the whole thing. Read George Will.

Michael Kinsley [emphasis mine]:

And can we rely on the government to spend enough? This also seems like a wonderfully upside-down problem. The answer is, apparently not. We’re going to need a second stimulus package, probably a third chapter of the bank bailout, more for the auto industry and others. It’s all going to cost at least two or three trillion. If it works, it will be money well spent. If it doesn’t work, that means we should have spent more.

He does go on to say, however, that all of this will lead to double digit inflation. He’s right about that.

In this year’s predictions entry, I stated that I thought a number of things would jump the shark this year:

Q: Name 3 things that will officially “jump the shark” in 2009:
A: American Idol, Top Chef, Blu-Ray

What I hadn’t figured was that the Federal Government would do it before even Blu-Ray did.

The fact that this stimulus bill is beyond a joke is reflected in the polls, in the behavior of Nancy Pelosi, and in every serious analysis of the bill I’ve seen. Daniel Henninger puts it well today:

Is the bill in Congress now a strong-form stimulus or a weak-form stimulus? If the latter, then it’s a waste of money. Martin Feldstein, an early supporter of stimulus, now says that the bill’s effects are weak and need a redo even if it takes a month or two.

If the Obama team won’t consider this, then why shouldn’t one conclude that their case for stimulus, as Mr. Obama suggested with his famous “stimulus is spending” remark, is indeed the crude cartoon version of Keynes, who suggested digging and refilling holes?

If this is true, that “this detail or that detail” don’t matter, then a number of conclusions follow:

The whole congressional effort is an irrelevant sideshow; only the final spending number matters. The economics don’t matter, because the real political purpose of the bill is to neutralize this issue until the economy recovers on its own. Much of its spending is a massive cash transfer to the party’s union constituencies; a percentage of that cash will flow back into the 2010 congressional races. The bill in great part is a Trojan horse of Democratic policies not related to anyone’s model of economic stimulus. Finally, if this bill’s details are irrelevant to the presumed multiplier effect of an $800 billion Keynesian stimulus, GOP Sen. Susan Collins’s good-faith participation in it looks rather foolish.

That’s the sophisticated way of putting it. The regular guy way is “That’s just blowing money up a wild hog’s ass.” But what strikes me about the wild hog comment, indeed everything I’m seeing in the reactions of nearly everyone around me, is everyone has resigned themselves to it, they don’t give a crap, and they’re planning for life under these weird, new circumstances. So while we watch Fonzarelli Obama prepare to take his magnificent jump across the shark, the country lets out a collective groan, dumps their stock portfolio and tries to change the economic channel as best they can.

For some people that means hunkering down and saving, for others it means buying gold and silver bars to bury in their basement. For others its all out survivalism time. For the economy as a whole, I suspect it means a growth in the black market, the underground economy that doesn’t get reported in to the government, that simply bypasses the whole nutty charade, unlicensed, in cash (whatever form that might take), and away from the capricious and greedy hands of Uncle Sam. After all, when the Secretary of the Treasury can’t be bothered to pay his taxes in full, why the hell should the rest of us, especially when our very savings are being taxed through blatant inflation in order to prop up Blue-State banking interests?

Forget it.

I suppose there’s some possibility that some of the states might want to rebel against this crap. But I suspect we’re witnessing the real beginning of the end here. If they were at all serious about this crisis, they would have started with reforming Fannie Mae and Freddie Mac. But instead they’re trying to re-inflate the housing bubble caused by those two entities instead, at the expense of literally every other part of the American economy.

This certainly isn’t what I had been hoping for.

The soda machine at work has had its prices increased from $0.70 to $0.75/can. That’s about 7%.

I think that’s what’s expected in the short term, inflation in non-durables with deflation in durables until inventories run out.

Must-read interview in the WSJ today with 92 year old economist Anna Schwartz, in which she sheds some insight on what is motivating the Fed and what they’re doing wrong:

Fed Chairman Ben Bernanke, of all people, should understand this, Ms. Schwartz says. In 2002, Mr. Bernanke, then a Federal Reserve Board governor, said in a speech in honor of Mr. Friedman’s 90th birthday, “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”

“This was [his] claim to be worthy of running the Fed,” she says. He was “familiar with history. He knew what had been done.” But perhaps this is actually Mr. Bernanke’s biggest problem. Today’s crisis isn’t a replay of the problem in the 1930s, but our central bankers have responded by using the tools they should have used then. They are fighting the last war. The result, she argues, has been failure. “I don’t see that they’ve achieved what they should have been trying to achieve. So my verdict on this present Fed leadership is that they have not really done their job.”

Read the interview with Anna Schwartz.

He’s for strengthening the dollar. Frankly, it’s the #1 issue for me right now, and I’m prepared to vote for him on the basis of that alone:

The underreported economic news of the week is that Barack Obama favors a stronger dollar. Even better, he thinks a stronger greenback would help to reduce oil prices.[...]

This ought to be a bigger story. In linking the dollar to oil prices, Mr. Obama is pointedly at odds with the Bush Administration and Federal Reserve, both of which blame high commodity prices on supply and demand, despite falling demand due to slower global growth. Fed officials — in particular, Vice Chairman Donald Kohn — have expressly rejected any strong link between the dollar’s collapse and the oil price surge since last August.[...]

Reuters also quoted Mr. Obama as saying “The way to strengthen the dollar is for us to get our economy back in shape.” On that point, he has it backward: Strengthening the dollar would help the economy — by making the U.S. a destination for capital, and especially by reducing the inflation in food and energy prices that has pounded the American middle class. Those price hikes may yet tilt the economy into a recession it could otherwise avoid.

We don’t know who is whispering in Mr. Obama’s ear about the dollar, but he’s on to a rich political vein. Americans know instinctively that something is wrong when the Canadian loonie is worth more than the greenback. Over to you, John McCain.

McCain is too busy fretting over celebrity to think about such things.

Read the entire WSJ editorial.

Most people who use that expression think it’s because we have troops stationed somewhere. And while I have no doubt that some people dislike our soldiers, our soldiers are such gentlemen and incidentally bring economic activity with them wherever that go, that I have trouble believing that they are the cause of much resentment.

No, what causes resentment is stuff like this:

For decades Latin America has been plagued by currency devaluations, inflation and lackluster growth. But just as some key countries have gotten serious about price stability and begun to reap the benefits through higher growth, the region is facing a new economic menace: the Federal Reserve.

The Fed is exporting inflation to the rest of the world as dollar-denominated commodity prices soar. The Latin American countries that keyed their currencies to an unofficial dollar standard are now finding that the standard is collapsing.

STOP BEN BERNANKE NOW!

A few links on economics for your morning perusal:

John Stossel on John McCain: “It would be nice if McCain would finally learn some economics.” Yep, it sure would.

Robert Samuelson on inflation, yet again: “Surveys show that people’s “inflationary expectations,” after years of stability, are rising. The Fed is holding its key interest rate at 2 percent, well below prevailing inflation. In the 1970s, this condition stoked inflation. An indecisive Fed risks repeating its previous blunder.”

Don Luskin on Obama’s cockeyed Social Security tax increase: “But the most alarming thing about Mr. Obama’s proposal is that the $250,000 threshold, above which the payroll tax would be applied, refers to household income, not individual income. So it’s quite deceptive when he claims that the $250,000 threshold will “ensure that lifting the payroll tax cap does not ensnare any middle class Americans.”

Suppose your household consists of you and your spouse, each earning wages of $150,000 per year. Currently, you are each subject to the payroll tax up to $102,000 of wages, so together you are taxed on $204,000. Under the Obama plan, you’d be taxed again on another $50,000 of wages.” YIKES!!!!!

According to Bob Novak, the fed isn’t planning to raise interest rates after all:

WASHINGTON, D.C. — Speculation that the Federal Reserve is about to begin inflation-fighting interest rate increases appears to be dead wrong. Fed Chairman Ben S. Bernanke is worried more about runaway oil prices contracting the global economy than inflating it with a wage-cost spiral. According to sources close to him, America’s leading central bank has no plans for a raise.

Should have figured.

Read Bob Novak.

I’ve spoken much about the Federal Reserve as of late, and yesterday even stated that today’s liberals seem to understand and believe in the market more so than today’s conservatives. But I was pretty surprised to see the Wall Street Journal coming out as far on the limb as I’ve come. After saying “about time” to Bernanke’s comments that it’s time to strengthen the dollar, they say this [emphasis mine]:

In this context, last week’s announcement of the August departure of Fed Governor Frederic Mishkin is good news. Mr. Mishkin is one of the intellectual architects of the Fed’s dollar debacle. His departure means the Fed will soon have three of seven seats unfilled, with one more Governor unconfirmed. The Senate seems disinclined to confirm any more Bush nominees, and that may be just as well. The next President deserves a chance to remake the Fed with sound-money appointees. This Administration has named too many academics who know a lot about monetary theory but too little about currency markets and price signals in the real world.

Wow man. Even the Journal has had it with these guys. While I do have my reservations about Obama, I suspect he gets monetary policy better than the current administration does.

Read the Wall Street Journal.

Larry Kudlow thinks that the Fed is getting ready to start backing the dollar again:

Fed chairman Ben Bernanke made big news Tuesday by singling out the weak foreign-exchange value of the U.S. dollar as the principal culprit in “the unwelcome rise in import prices and consumer price inflation.”

Are you watching this, John McCain?

Bernanke is signaling a major policy shift on the dollar. In his speech, via satellite to a conference in Barcelona, Spain, he said Fed policy and the underlying strength of the U.S. economy “will be key factors ensuring that the dollar remains a strong and stable currency.”

In effect, the Fed chief is putting a floor under the dollar. But there’s more here. He added that “we are attentive to the implications of changes in the value of the dollar for inflation and inflation expectations, and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations.”

The Fed head has finally figured out that the weak dollar is driving up inflation. He’s also reaffirming the Fed’s traditional priority of generating price stability. In the process, he may be restoring an inflation-targeting policy that has been badly undermined of late. Hopefully this means the central bank will go back to using forward-looking market-price indicators, such as the dollar and gold, in its policy decisions.

Let’s hope he’s right. Oh, and then there’s this:

But without question, Bernanke would not have changed his language unless he got a signoff from Paulson. So these new statements are the most hopeful sign yet that U.S. financial bigwigs are starting to get their arms around the greenback.

I knew Bush wouldn’t pick an independent Fed chairman. He’s just a lackey.

Read Larry Kudlow.

The Wall Street Journal editorializes on the Fed:

So the Federal Reserve is signaling that its rate-cutting binge may finally be over, and we can be grateful for that small favor. The consequences of its easy-money bender will roll through the economy for years to come, however, so it’s important to draw the right lessons.

All the more so because the Fed’s most senior officials continue to insist that recent price increases have almost nothing to do with . . . monetary policy. Imagine that. The latest to wash his hands of responsibility for the value of the currency is Donald Kohn, the Fed’s current Vice Chairman and long-time resident intellectual. In a speech in New Orleans this week, Mr. Kohn acknowledged soaring oil and food prices, but he blamed them on global supply and demand for corn, oil and so on.

“As interest rates in the United States fell relative to those abroad, the dollar declined, which could have boosted the prices of commodities commonly priced in dollars by reducing their cost in terms of other currencies,” Mr. Kohn explained. “But the prices of commodities have risen substantially in terms of all currencies, not just the dollar. In sum, lower interest rates and the reduced foreign exchange value of the dollar may have played a role in the rise in the prices of oil and other commodities, but it probably has been a small one.”

If Mr. Kohn really believes this, we’re in more trouble than we thought.

You can say that again.

Read the whole thing here.

More here.

UPDATE: I should also point out that just because the Fed has indicated that they are going to stop lowering rates, doesn’t mean that there’s going to be an end to inflation any time soon. Rates are still too low. They should be up around 5% at least. We can expect inflation to continue until such time as the Feds raise rates back up to normal levels.

Ever hear of bracket creep? With inflation on the rise, you soon will. Especially if Obama’s tax plans as they’re currently outlined become enacted.

Bracket creep is the process where people’s taxes are raised because their salaries rise due to inflation and they are thus pushed into a higher tax bracket. So say your salary doubles due to inflation. You’re not any richer, and you’re certainly not rich, but suddenly you’re in a tax bracket for rich people because your nominal salary doubled in terms of dollars, even though it stayed the same in terms of wealth. That’s bracket creep.

One of the great triumphs of the Reagan legacy was that they got rid of bracket creep by indexing the tax brackets for inflation. Now obviously this gives the government every incentive to underestimate the effects of inflation, but it’s better than nothing. Now, apparently, there was no such provision written into the Bush tax cuts when they expire, meaning that the brackets revert back to the way they were in 2000 or so, before Bush took office, before all this inflation took place. Scared yet? Andrew Biggs comments:

Tax revenues would skyrocket if the tax cuts expire, due to “bracket creep.” Average incomes are higher today than in the 1990s, but income-tax brackets aren’t adjusted for the growth of earnings. As a result, Americans will shift into higher tax brackets and pay a greater share of their incomes in taxes.

Going back to the tax rates of the 1990s doesn’t mean that households will pay 1990s taxes. Because the tax brackets haven’t risen along with incomes, average taxes would be significantly higher, and grow each year.

If the tax cuts expire, income-tax revenues by 2018 will rise to 10.8% of the total economy from 8.7% today – an increase of 24%. Compared to the average over the last 50 years, allowing the rates to rise would increase tax revenues by 32%.

Believe it or not, income taxes will rise even if the tax cuts remain in place, because the revenue-increasing effects of bracket creep more than offset the lower rates. With the lower rates, total income-tax revenues will increase to 9.3% of GDP by 2018. This level is 7% higher than today, and 13% above the 1957-2007 average.

Obama had best address this issue if he wants to let the Bush tax cuts expire, because otherwise he is suggesting an enormous tax increase on the American people. Furthermore, he should also suggest indexing capital gains taxes for inflation in exchange for raising the rate as he wants to. That would at least be a fair trade-off.

Read Andrew Biggs.

When the Wall Street Journal is telling you that your policies are designed to rob Main Street to give the money to Wall Street, you know it’s gotten bad:

So Federal Reserve officials are whispering to reporters that they will consider a “pause” after another interest-rate cut this week. Perhaps we should be more respectful, but this sounds like the alcoholic who tells his wife he’ll quit drinking next weekend, after one more bender. What Chairman Ben Bernanke needs isn’t a gradual withdrawal from easy money but membership in Central Bankers Anonymous.

* * *

Eight months into the Fed’s most recent rate-cutting spree, the evidence is overwhelming that it has been a major policy mistake. Aggressive rate cutting – taking the fed funds rate to 2.25% from 5.25% last September – has had little effect on the banking crisis it was supposed to ease.[...]

The practical impact has been to send energy and food prices soaring. This is a direct tax on both the world’s poor and America’s middle class. Just when the U.S. economy needs a resilient consumer given the fall in housing prices, these price increases have eviscerated consumer pocketbooks. In its attempt to help Wall Street and the financial system, Fed policy is punishing average Americans. The public is frustrated and angry with these price increases, and it has a right to be. Inflation is the thief of the thrifty middle class.

And we wonder why people refuse to save.

Be sure to read the whole thing.

Please, Lord, when will it end???

Caught this interesting link over at Instapundit. Basically, fuel and food prices correlate 90% to the decline in the dollar. Go figure:

The chart below shows the price of 100 pounds of rice against the euro’s parity against the US dollar during the past 12 months. The regression fit is 90%. There is an even tighter relationship between the price of rice and the price of oil, another store of value against dollar depreciation.

As the chart makes clear, the ascent of the cost of rice to $24 from $10 per hundredweight over the past year tracks the declining value of the American dollar. The link between the declining parity of the US unit and the rising price of commodities, including oil as well as rice and other wares, is indisputable. China has bid aggressively for rice all year, and last week banned rice exports, along with Vietnam and several other producers.

For developing countries whose currencies track the American dollar and whose purchasing power declines along with the American unit, this is a catastrophe, as World Bank president Robert Zoellick warned the Group of Seven industrial nations in Washington last week. Food security suddenly has become the top item on the strategic agenda.

Be sure to read the whole thing.

Also, Robert Samuelson today talks about the effects that changing demographics have on the economy:

The “life cycle” (aka demographics) also promoted the shopping extravaganza. People borrow and spend more in their 30s and 40s, as they buy homes and raise children. In the 1980s and 1990s, many baby boomers were passing through their peak spending years. That reinforced the wealth effect. Finally, the “democratization of credit” supported the shopping spree. At the end of World War II, it was hard for most Americans to borrow. Since then, mortgages, auto loans and personal credit have been liberalized. By 2004, three-quarters of U.S. households had debt.

All these forces for more debt and spending are now reversing. The stock and real-estate “bubbles” have burst. Feeling poorer, people may save more from their annual incomes; it’s already much harder to borrow against higher home values. Demographics tell the same story. “Life-cycle spending drops among 55- to 64-year-olds” — they borrow less and their incomes decline — “and that’s where our household growth is now,” says Susan Sterne of Economic Analysis Associates.

And credit “democratization”? Well, the message of the subprime-mortgage debacle is that it went too far. Up to a point, the spread of credit was a boon. Homeownership increased; people had more flexibility in planning major purchases. But aggressive — and often abusive — marketers peddled credit to people who couldn’t handle it. There are no longer large unserved markets of creditworthy consumers. Indeed, many Americans are overextended. In 2007, household debt (including mortgages) totaled $14.4 trillion, or 139 percent of personal disposable income. As recently as 2000, those figures were $7.4 trillion and 103 percent of income.

The resulting retrenchment of consumer spending is already being felt. “Retailing Chains Caught in a Wave of Bankruptcies,” headlined The New York Times last week. [...]

[W]hat if nothing takes the place of the debt-driven consumption boom? Its sequel is an extended period of lackluster growth and job creation. Somber thought. The ebbing shopping spree may challenge the next president in ways that none of the candidates has yet contemplated.

Now put those both together. Inflation while the economy is showing down due to an aging population. Remember the Jimmy Carter years, when senior citizens ate dog food because inflation has turned their SS check into nothing? I do…

The future looks bleak indeed.

I have long thought that the policy of the Federal Reserve was to inflate the currency so as to keep home prices steady. Now people are explicitly calling for the Fed to do just that:

The policy alternatives in the post-housing-bubble world are painfully unpleasant. In my view, the least bad option is for the Federal Reserve to print money to help stabilize housing prices and financial markets. Yes, use reflation to soften the pain for Main Street and Wall Street. If instead we let housing prices fall another 25%-30% – as predicted by the Case-Shiller Home Price Index – it’s almost certain that Washington will end up nationalizing the mortgage business.

Right, except the problem is that creating a 25%-30% inflation in the currency over a short time is madness, and will be extremely disruptive (and destructive) to the rest of the economy. By contrast, nationalizing the mortgage business at least denies the players in the financial services industries their cash-outs. Honestly, I think the whole thing should fall. I really think the rest of the economy (non-housing/banking) could withstand the hit.

Meanwhile, the WSJ editorial board thinks that the G-7 have had enough of the weak dollar, and about to intervene on its behalf:

Awakening from their long slumber, the G-7 finance ministers have finally admitted that a global run on the dollar is a bad idea. The currency markets will no doubt begin testing immediately to see if they mean it.

At their weekend meetings in Washington, the G-7 ministers dropped their long neglect of the dollar and noted that “Since our last meeting, there have been at times sharp fluctuations in major currencies, and we are concerned about their possible implications for economic and financial stability. We continue to monitor exchange rates closely, and cooperate as appropriate.” Translation: We don’t want the dollar to keep falling, and speculators might get burned if they bet on further dollar declines.

I would say: refinance your mortgage now, because we may be about to get a taste of the return of Paul Volcker style interest rate rises. Actually, it probably won’t start until the Presidential elections are over in November, or maybe just a little before.

This is priceless:

The Fed is like King Canute with a difference — it is trying to halt an ebbing tide rather than a rising one. Its liquidity injection seems huge at $200 billion (with perhaps more to follow), but it is still only equivalent to one-third of the expected losses in the NDFI sector.

Moreover, the Fed’s readiness to accept almost any asset at just below face value as collateral will prevent price discovery. That means the U.S. financial system will remain burdened with uncleansed balance sheets that penalize future lending and economic growth.

Creating a lot of liquidity does not resolve an issue of solvency, which is now the driver of credit contraction. All the Fed will achieve is a dollar that will be further debased and inflation that will be higher. It cannot stop the process of deleveraging and asset price decline.

King Canute, for those not in the know, tried to bail out the ocean with a bucket.

I think we’re heading for a Japanese style decades-long recession, unless somebody stops the Fed and these securities are allowed to price correctly.

Read David Roche.

Previously: Who Owns Who? and Ahead Of The Curve

So the Fed did as expected. The WSJ editorial board thinks it’s fine and dandy:

The move continued what we’ve argued is the Fed’s best policy course in this crisis, which is to serve as a facilitator of markets frozen by uncertainty. On that point, the central bankers will supply some $200 billion in Treasury securities for 28 days in return for mortgage-backed securities as collateral. This is intended to increase the demand for MBSs, which few seem to want in the current climate. In other words, the Fed is trying to supply liquidity to revive a market locked up by fear.

Holman Jenkins is not so sure:

Is a housing bailout the solution for clogged-up credit markets and a faltering economy? What the Fed has been doing and did again yesterday hasn’t really worked, notwithstanding the pops it produces in the stock market every time it shovels liquidity into the system. The Fed’s latest move provides financial institutions another $200 billion in direct short-term lending against their unsaleable housing collateral. The Dow Jones jumped 416 points. But it won’t restart markets for the underlying collateral.

Where are the speculators, vultures and hedge funds? Where are the big money players willing to buy the exotic but still substantial mortgage-backed securities for which markets have ceased? The Fed’s liquidity rush seems only to have convinced them the time is ripe for staying on the sidelines.

To get to a real solution, speculators and investors need to believe that home prices are hitting bottom, that any mortgage debt they might buy today for 80 cents on the dollar today won’t be worth 30 cents tomorrow. Then the vultures will pile in: The transfer of wealth from the overleveraged banks and hedge funds to those who kept cash handy will be shocking, ugly and cathartic — but it will also be relatively quick. Credit markets will begin to function again. The economy will grow.

Jenkins is right. This move by the Fed is designed to enable the banks to pass their losses off on the Fed, and pretend that the write-downs they need to take, the losses they need to incur, aren’t really there. It’s designed to prop up housing prices, not let them fall to where they need to be. And it will work in a sense, insofar as inflation will keep housing prices high.

Frankly, I think this is VERY bad news for the economy.

Read my thoughts about this from two days ago here.

Yes, I’m ranting about inflation again.

Consensus seems to be that inflation is currently at 4%, which is what spawned Nixon to impose wage and price controls on the economy. The Fed isn’t worried because “core inflation” is only 2.7%.

So the Federal Reserve has continued lowering interest rates. But lowering the fed funds rate is only one of three mechanisms that the Fed has for injecting currency into the economy. The other two are open market operations and changing the reserve requirements for member banks. Wikipedia puts it pretty well, in an otherwise awful entry about the Federal Reserve [emphasis mine]:

There are three main tools of monetary policy that the Federal Reserve uses to influence the amount of reserves in private banks:[29]

1. open market operations – purchases and sales of U.S. Treasury and federal agency securities–the Federal Reserve’s principal tool for implementing monetary policy. The Federal Reserve’s objective for open market operations has varied over the years. During the 1980s, the focus gradually shifted toward attaining a specified level of the federal funds rate (the rate that banks charge each other for overnight loans of federal funds, which are the reserves held by banks at the Fed), a process that was largely complete by the end of the decade.[32]
2. discount rate – the interest rate charged to commercial banks and other depository institutions on loans they receive from their regional Federal Reserve Bank’s lending facility–the discount window.[33]
3. reserve requirements – the amount of funds that a depository institution must hold in reserve against specified deposit liabilities.[34]

Those are the three basic tools that are at the disposal of the Fed. Every student in macroeconomics learns this. The thing to focus on here, is #1. What this is saying is that when the government issues debt, the Fed is always there to guarantee a buyer for that debt. Since the Fed creates money out of thin air, this act, of buying paper from the government, is an act of inflation. The debt is never really expected to be retired.

Of course, this is all sort of a devil’s bargain. But at least when the Fed is buying Treasury bonds, they’re paying for our debt. Granted, it amounts to a tax on anyone with a dollar in their hand, it’s still justifiable in that we elected our congress, they do our bidding, and if we want them to spend that kind of money, we have to pay the price. If we don’t want the currency inflated, the easiest thing to do is to instruct congress to cease deficit spending.

But what if the Fed started buying all sorts of junk, to keep particular businesses afloat? Junk that they knew had no value, and would never be redeemable for anything? And not just any junk, but private junk (as opposed to Treasury bills), meaning that the beneficiaries aren’t you and me through the spending we authorized congress to engage in, but some rich dude who got himself into hot water? Well, check this out:

The Fed offered the first $15B of repo loans under the program today, so we can see how things are going to work. First, how did the Fed square the circle of ramping up its repos without pushing down the Federal Funds rate? Just as it had done with TAF, the Fed offset the “temporary” injection of funds with a “permanent open market operation”. The Fed purchased outright $10B of Treasury securities today at the same time as it offered $15B in exchange for mortgage-backed securities under the new program (at a low interest rate than in traditional repos against MBS collateral). The net cash injection was small, but the composition of securities on bank balance sheets changed markedly, as illiquid securities were exchanged for liquid Treasuries.

In James Hamilton’s wonderful coinage, the Fed is conducting monetary policy on the asset side of the balance sheet. This is an innovation of the Bernanke Fed. Conventionally, monetary policy is about managing the quantity of the central bank’s core liability, currency outstanding. When the Fed wants to loosen, it expands its liabilities by issuing cash in exchange for securities. When it wants to tighten, it redeems cash for securities, reducing Fed liabilities. The asset side is conventionally an afterthought, “government securities”. But the Bernanke Fed has branched out. It has sought to lend against a wide-range of assets, actively seeking to replace securities about which the market seems spooked with safe-haven Treasuries on bank balance sheets without creating new cash. By doing this, the Fed hopes to square the circle of helping banks through their “liquidity crisis” without provoking a broad inflation.

Got that? The Fed took Treasury securities it bought on the open market, and in effect traded them for mortgage backed crap from America’s largest banks. The Treasuries are tradeable on the open market, but the mortgage backed securities, consisting of human refuse, are not. Therefore, the Fed bails out the banks not by issuing more currency directly, but by trading liquid assets for non-liquid junk. Nobody really knows what it means for the Fed to write off worthless assets, since it was only supposed to be dealing in US Treasuries, but it seems to me that the basic effect is to inject cash into the banking system.

Be sure to read the whole thing, as I’m grossly simplifying here.

The title of the piece I’m quoting is, “Covert Nationalization of the Banking System”. The thinking here goes, that the Fed is loaning money to the private banks that they cannot really pay off, resulting in de-facto ownership of the US banking system by the Federal Reserve.

But that conclusion gets it precisely backwards. The assumption in that conclusion is that the Federal Reserve is an appendage to the Federal Government. While it may be a creature of congress, the Federal Reserve is PRIVATELY OWNED by each of it’s member banks. As the Federal Reserve itself puts it:

For example, the Reserve Banks issue shares of stock to member banks. However, owning Reserve Bank stock is quite different from owning stock in a private company. The Reserve Banks are not operated for profit, and ownership of a certain amount of stock is, by law, a condition of membership in the System. The stock may not be sold, traded, or pledged as security for a loan; dividends are, by law, 6 percent per year.

Got that? Let it sink in now. The Federal Reserve is inflating our currency, passing what is in effect a tax on ever dollar we hold in our hands, in order to benefit its shareholders, who are the member banks, basically every bank in the United States. It’s not we, via the Federal Government who are nationalizing the banks. Rather it is the banks, through their instrument of the Federal Reserve, who are owning us.

Now just pause and let that sink in.

Our currency is being inflated, our wealth being stolen from us, to benefit Wall Street banks who have not ceased paying bonuses and dividends. It’s an unbelievable scandal. Somebody needs to stop it.

The problem is that few politicians and fewer reporters really understand economics at all. And so they have no understanding of the changes that have been happening. Be sure to go read the entire article here. I had to read it a few times before it sank in. These banks need to fail (or if we are to bail them out, bonuses need to be returned and consequences need to follow). This is a far bigger scandal than Enron. With Enron, congress overreacted and passed nonsense legislation to show they were doing something. Here they do nothing. And this is when they’re supposed to do something!

I suspect some part of that is that the Democrats run congress, and the banks are all located in Blue states. Those reps and senators can claim to be helping the “poor people being foreclosed on” while they’re in fact helping out their banker constituents all the while letting us be screwed by the Fed. Man, I’m pissed.

Read it again here. (via Jake)

This is about as explicit an admission as you’re gonna get:

First, Fed Vice Chairman Don Kohn declared that, while inflation was worrisome, the Fed now views recession as the more urgent danger to fight. Then on Wednesday, Fed Chairman Ben Bernanke told Congress that the Fed will do whatever it takes to stop the credit squeeze from becoming a recession. That’s about as close as a central banker will get to saying that he’s thrown price stability to the wind. If inflation rises — as it now surely will — then the Fed will worry about that later, after the economy is safely past the credit crunch.

So there you have it. The Fed is going to print more money, thus devaluing yours, and hand it to banks so they can get out of the hole they’re in. They are literally going to take from the regular working schmoe out in normal America and give that money to bankers, who incidentally continue to pay out bonuses and dividends.

It’s completely infuriating. I predict that the first candidate to pick up on this (and condemn it) will become the next President. And yes, I know Ron Paul was out there, but he was too anti-war for the Republican party, and the problem wasn’t clear enough in most American’s minds to be capitalized on. It still may not be, but by November, LOOK OUT!

Here’s to hoping Steve Forbes can talk some economic sense to John McCain, or Goolsby to Obama.

Read the whole thing here.

Holman Jenkins gets it right:

The truth today is that politicians are rushing to prop up house prices not to rescue the poor from the ignominy of renting, but to get past the next election without affluent voters having to confront a realistic decline in the market value of their main assets.

Most of these homeowners are still above-water in their home equity; though job changes or the prospect of job changes may make them sensitive to current market prices, many are not in need of selling.

In the meantime, drawing out the correction prevents the market from finding a bottom. It prevents owners and shoppers alike from having confidence to judge what houses are worth. It bails out lenders and investors who incautiously or fraudulently financed home purchases for speculative buyers, which can only encourage more of the same behavior in the future.[...]

A more honest use of taxpayer money at least would be to buy up houses at foreclosure auctions and demolish them, especially in neighborhoods likely never to recover. The true fillip to “social stability” right now would be to nip in the bud the blighted, suburban slums of the future.

I am seriously pessimistic about the economy right now. The market is not being allowed to correct itself, and we are all paying for the banks mistakes via the hidden tax of inflation. Speaking of which, here’s David Ranson:

Markets look forward, while government surveys of the cost of living are a rearview mirror. A little “indicator analysis” shows that commodity prices, far from reverting quickly back to the mean, are early-warning indicators of the future CPI [Consumer Price Index]. Last year’s large increases in energy and food imply that consumer-price inflation is going to be much closer to today’s “headline” rate of 4.3% than the “core” rate of 2.5%.

Why does this matter? The accompanying graph shows how rapidly the purchasing power of income declines from an ongoing inflation of 4%. After nine years, an income of $100,000 is worth only $70,000. After 17 years its purchasing power has been cut in half, and after 30 years by about 70%.[...]

But worse may be yet to come. While commodities like energy and food are leading indicators of the CPI, precious metals like gold are, in turn, leading indicators of energy and food. It’s sobering to note that precious-metals prices this year are running more than 30% ahead of where they were a year ago.[...]

There is a remarkable parallel between annual CPI inflation and the cumulative change in the price of gold measured from eight years before. A similar graph could be plotted for silver, and the parallel can also be seen in cross-section by comparing countries over time with varying degrees of currency instability.[...]

But taken as a whole, the relationship suggests my following rule of thumb to estimate CPI inflation at any time: Divide the percentage change in the gold price from eight years in the past by 80, and add three. This rule of thumb has largely worked over the past several decades. In the last eight years the price of gold has risen 225%. The rule therefore comes out with an answer that puts inflation a lot closer to 6% than 4%.

From reading these two articles in succession, I would infer that the Federal Government’s policy (and I suppose by extension the Federal Reserve’s) is to inflate the currency to bail out banks, and preserve home prices in relative dollars, while hoping nobody notices their income dropping and their real purchasing power dropping like a stone. Real nice.

Anybody have any good ideas about where to invest?

UPDATE: More from Robert Samuelson [emphasis mine]:

The more upsetting figures are those for the last three months. In this period, the full CPI rose at a 6.8 percent annual rate. Without food and energy, the increase was still 3.1 percent. Medical services were up 5.1 percent, women’s and girls’ apparel 7.3 percent (again, at annual rates). Inflation is accelerating.

Price increases of individual items can have many immediate causes: poor harvests for food; OPEC for energy; uncompetitive markets for health care; corporate market power for drugs. But persistent inflation — the general rise of most prices — has only one cause: too much money chasing too few goods. It’s not a random accident. The Federal Reserve regulates the nation’s supply of money and credit. The Fed creates inflation and can control it.

Since August, the Fed has been under enormous pressure to ease money and credit. It has. The overnight Fed funds rate has fallen from 5.25 percent in early September to 3 percent now. Politicians are clamoring for the Fed to prevent a recession. Banks and other financial institutions want cheaper credit to enable them to offset losses on subprime mortgages. There is fear of a wider economic crisis if large losses erode confidence and, by depleting the capital of banks and other financial institutions, undermine their ability and willingness to lend and invest.

Unfortunately, the Fed shows signs of overreacting to these pressures and repeating the great blunder of the 1970s. Underestimating inflation then, the Fed repeatedly shoved out too much money and credit in a vain effort to keep the economy near “full employment.” Now, switch to the present. Again, the Fed has underestimated inflation. It expected the economic slowdown to suppress inflation spontaneously. But so far, the lower inflation hasn’t materialized in part because, outside of housing, there hasn’t been much of an economic slowdown.[...]

If most of those excesses aren’t given the time to self-correct, we may be trading modest pain today for much greater pain tomorrow. Trying to prevent a recession at all costs is a fool’s errand that could ultimately backfire on us all.

Will anybody listen???

UPDATE 2: Yet more from Larry Kudlow.