The inflation hedge of choice

On Wednesday, the US Federal Reserve "shocked the world" by announcing plans to buy $300bn of government debt and double its purchases of Fannie and Freddie securities. According to the FT, once the Fed's plans are fully realized its balance sheet could swell to $4,ooobn, one third the size of the US economy. Hellicopter Ben, meet Bazooka Ben.

The Fed's actions are an attempt to literally shock life into the credit markets. It may also have the convenient effect of driving down the cost of government borrowing. However, the Fed runs the very real risk of stoking a very big inflationary problem down the road. Weimar Republic the US is not, but the money supply is growing at such a rapid rate that the Fed had better hope the US economy rebounds this year. Remember central bankers, there are unintended consequences to such dramatic monetary easing; like say, a housing bubble (Mr Greenspan, I'm looking in your direction).

What then are some of the likely consequences of the Fed's policy innovations? For one, the dollar was the big loser last week; in fact, it registered its worst week against the major currencies in 24 years. This fed into an accelerating rally in commodities, the moment's inflation hedge of choice. The benchmark S&P GSCI index was up 8% last week. Or take copper, up some 28% this year, a feat completely divorced from the underlying fundamentals. Though, the FT has an article this morning on the actions of a "secretive" Chinese state institution stockpiling copper supplies (which sounds like the perfect plot for Bond film). Oil is back over $50, supported by the OPEC cuts, but boosted in recent weeks by Fed policy. The speculative inflow into commodities, as an asset class, may be small compared to the bubble of recent years, but it is nonetheless paring the steep losses experienced in the second half of 2008.

The sustainability of this rally is highly suspect. With Chinese growth forecast at 6% for the year, and the G7 contracting by 3.2%, the global recession will depress demand for commodities well into the year (with the possible exception of food, but that's another discussion). However, loosey-goosey monetary policy (as A-Rod would call it) comes at a price, with inflation second only to a loss of confidence in US treasuries. Bernanke has demonstrated that he is willing to throw everything in the Fed's arsenal at the credit markets. Until he wins, expect commodities to outperform as an asset class.

(photo courtesy of Shiny Things' photostream)

Warmflation

Thomas Friedman's piece in the New York Times yesterday was nothing special. In fact it amazes me how often such dribble is placed on the Op-Ed pages of major newspapers. Vague references to anecdotal experiences of climate change backed with murky statistics and little fact. Even if you're an ardent environmentalist, the cliched, opaque writing is tough to swallow.

That being said, he manages to produce one interesting thought (not original, but an opinion of Minik Thorleif Rosing, an accompanying Danish geologist).

" 'Most people will actually feel climate change delivered to them by the postman,' he explains. It will come in the form of higher water bills, because of increased droughts in some areas; higher energy bills, because the use of fossil fuels becomes prohibitive; and higher insurance and mortgage rates, because of much more violently unpredictable weather. "

Not only does this strike me as incredibly insightful and true (regardless of how much we may improve energy efficiency), but it raises an interesting question given the existing economic worries. Could the effects of climate change collude with rising commodity prices to increase, and even entrench, inflation? Some economists are already preaching the danger of entrenching inflationary expectations. And they are right to do so. Expectations of continuing inflation affects consumer behavior and could do much to offset recent actions aimed at promoting, or at least, maintaining growth.

Ben Bernanke's job is hard enough. You better believe financial organizaitons will start pricing inflation into their lending and investing practices but central bankers should not be forced to consider such subtle (and even tenuous) connections in shaping monetary policy. But if politicians do not start seriously confronting the dangers climate change poses across the board then the men at the Fed may soon find themselves with NO room left between the rock and the hard place. Whether funded with carbon or windfall taxes (let's hope not), while credit remains tight, "green subsidies" may not only save the planet, but perhaps even our dollar.

Monetary policy: Between a rock and a hard place

Blog note: sorry for being off the radar for a few days - the next few weeks are crunch time for my Master's dissertation. Fortunately, I see my illustrious coauthor has kept you entertained with stories about kites, voicemail, and Schlitz. I'll do my absolute best to keep posting at least once a day.

Anyways, right now is a good time to thank your lucky stars that your name isn't Ben Bernanke and that your business cards don't read "Chairman of the Federal Reserve." Mr. Bernanke is facing a daunting combination of high inflation (year-to-year inflation in June was 4.1%, the largest annual increase since May 1991), anemic growth (1.9% in the 2Q, largely on the back of fiscal stimulus checks), and stubbornly high food and energy prices.

Going into the Fed's August meeting on Tuesday, it's an impossible position to be in. Raise interest rates and you risk aggravating a delicate situation where credit remains tight, energy prices remain volatile, and the housing market may not have quite bottomed out yet. Lower interest rates and you risk stoking the fires of inflation.

What to do? Realistically, probably nothing. In June, the last time the Fed met, they left interest rates unchanged at 2%. Wall Street is betting that they'll do the same thing this time, and I think they've got it right. When interest rates are this low, realistically it's hard to lower them much further, and Mr. Bernanke is still more concerned about pumping liquidity into the system than inflation. The real question becomes: how much inflation is Mr. Bernanke willing to tolerate? If he wants to keep rates this low, it will have to be a lot.

Inflation woes

The Central Bank of Zimbabwe is set to lop some more zeroes off the Zimbabwe dollar. They knocked off three back in 2006, and this round is set to see another 3-6 zeroes get the chop. Excuse this humble commentator for his cynicism, but when the annual rate of inflation is above 2.2 million per cent, this isn't going to help much. It will likely improve transaction efficiency for a short period of time, but unless Zimbabwe takes some concrete steps to rein in inflation, sooner than later the currency will be just as worthless as it is today.

Venezuela tried this trick last year, when it introduced the Strong Bolivar, which President Hugo Chavez promised would help curb inflation. A 'Strong' Bolivar is essentially just a normal Bolivar, Venezuela's unit of currency, with three zeroes lopped off. Unfortunately, Venezuelan inflation has actually gotten worse since then, reaching 32% in Caracas in the month of June.

I wrote last month about how inflation is fast becoming a major financial worry. This is especially true in developing countries and emerging markets . As painful as the medicine may be, now is the time when such countries should be prioritizing inflation control over economic growth. The short term losses are undesirable, but the long term dangers are too real to ignore. Keynes said it best:

As inflation proceeds and the real value of the currency fluctuates wildly from month to month, all permanent relations between debtors and creditors, which form the ultimate foundations of capitalism, become so utterly disordered as to be almost meaningless; and the process of wealth-getting degenerates into a gamble and a lottery.

It's troubling when there exists such chronic financial mismanagement in economies like Venezuela and Zimbabwe, which could both be in much better shape than they are. But they're not, and unfortunately it is the citizens of those countries who pay the highest price for that.

Steady as she goes

The FED opted yesterday to keep interest rates at 2%, indicating that while inflation is a growing concern, it is still secondary to stimulating growth. Meanwhile, the ECB is getting even more hawkish on the issue, with Trichet signaling that they will likely raise rates by 0.25 points to 4.25%.

Essentially, the US and the EU are taking opposite bets on what's a bigger economic threat: recession or inflation. In a way this is par for the course: as an institution modeled on the Bundesbank, the ECB is much more inflation-adverse by design. But you can't help wonder if somebody's making a mistake.

That the dollar is still the world's primary reserve currency only complicates things. Countries pegged to the dollar cede their monetary autonomy to the FED and have to follow its decisions or get knocked off their peg. In China, where inflation is closer to 8%, low interest rates are probably not what you want.

Add to this the fact that lower interest rates are more likely to cause further dollar depreciation, and you've got some real problems. Especially when you need to import things like oil (black gold, Texas tea), where contracts are denominated in dollars. If dollars are worth less, it will drive up the price. 

Spooky, scary, indeed.