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How the Fed lost the inflation fight
Despite powerful tools, the Fed looks feeble against today's storm of inflationary pressures. Here's why inflation is winning out.
By Jim Jubak
The Federal Reserve has lost the battle against inflation.
Oh, sure the bank will keep raising interest rates -- as it did on Tuesday, when it increased the federal funds rate to 3.75% -- in an effort to fight rising prices. And, sure, measured core inflation -- the rate of increase in prices minus food and energy -- is up at an annual 1% rate in the last five months.
But the battle is over, nonetheless, whether the Federal Reserve will admit it or not. (And I'd guess "not," since saying anything else would send the financial markets into a tizzy.)
Why? Because actual future inflation is driven by current expectations of inflation. In other words, folks raise prices because they expect inflation in the future. And because the factors setting current expectations of inflation are largely outside the Federal Reserve's control, there's very little Alan Greenspan & Co. can do to stop an inflationary psychology from becoming embedded in the economy.
Let me explain why I think the battle is over and inflation has won.
The Federal Reserve has powerful weapons for fighting inflation.- Tool 1: The Federal Reserve can raise interest rates, making credit more expensive, slowing the economy and keeping price increases to a minimum. Businesses don't raise prices, by and large, when the economy is slowing.
- Tool 2: The Fed can gradually shrink the money supply, making credit more expensive and harder to get, slowing the economy, and keeping price increases to a minimum.
Both of these measures work to put a damper on the prices of assets like stocks and houses. Taking money out of the pockets of investors and homeowners (or at least not putting more money in their pockets to spend) works to decrease demand, slow the economy, and keep price increases to a minimum.
Shutting down an easy trade
And these weapons have shown some of their historical ability to move the financial markets. So, for example, the 11 increases in short-term interest rates since the Federal Reserve began raising rates on June 30, 2004, have just about closed out the carry trade that let banks and investment banks, bond traders and hedge funds of all flavors make money by borrowing at low short-term rates and then lending (or buying) at higher long-term rates. The yield spread, though, between a 10-year Treasury note (yielding 4.18% as of Sept. 21) and a two-year Treasury note (yielding 3.94%) has just about vanished. And the spread between the 10-year note and the Fed funds rate after yesterday's rate increase is down to just 0.43 percentage points. That's a huge decline from the gap in June of 2004, of 3.75 percentage points, that enabled bond traders to mint money.
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That shrinkage in the spread has, as you'd expect, cut profits throughout the financial sector and looks set to cut profits more. For example, Annaly Mortgage Management (NLY, news, msgs), a manager of a portfolio of mortgage assets, warned Sept. 16 that the Fed's interest-rate hikes are causing its borrowing costs to outpace the return on its investments. As an indicator that the company doesn't see this trend turning around quickly, Annaly Mortgage Management cut its dividend by 64%.
But even in the financial markets and on Wall Street, the Fed's moves have had much less effect than they used to. Thanks to the derivatives market -- a largely unregulated market that dwarfs the amount of actual U.S. currency in circulation -- traders, speculators, and even many who would once have been called investors think they can keep the game going in spite of the Fed. (Ill have a column soon on that topic.) The Federal Reserve's power over the financial markets just isn't what it used to be.
The supply side of the equation
The traditional inflation-fighting weapons aren't very well-suited to damping inflation in the current economy. First, because this is supply-led rather than demand-led inflation, and second, because the prime source of inflationary expectations is our federal government in Washington.
Federal Reserve interest-rate increases, slowing money-supply growth and other traditional policy tools are most effective in fighting inflation when potential price increases are demand-driven. In other words, making money more expensive or less available is a pretty good way to fight inflation when companies start to raise prices because of growing demand for more of this and more of that.
But current inflationary pressures are, while still linked to demand, more supply-driven. For example, it's because OPEC (the Organization of the Petroleum Exporting Countries) has no surplus supply of oil to put on the market -- at any price -- that oil prices have soared, driving up the cost of everything that runs on or is made from petroleum. This isn't just an OPEC problem: OPEC notes that while, since 2000, it has increased its production of sweet crude, the only kind that many older refineries can turn into gasoline and other petroleum products, global production has actually dropped.
The global economy is supply-constrained in industries from mining to lumber to oil refining, largely because companies haven't invested enough in production capacity over the last few decades. There's no puzzle or global plot here, just economics. The profits in many of these industries were so low that nobody invested in new production capacity.
The good news is that this cycle will turn, as such cycles do, as current high profits, created by this very lack of supply, are invested in new capacity. Eventually supply will catch up -- as long as the profits are there, it always does. (Unless the world is indeed facing a growing shortage of discoverable and recoverable oil, and the jury is still out on that one.) And if this cycle is like most, companies will overinvest, lured by current and temporary high profit margins, setting the stage for a period in many of these industries when supply again exceeds demand.
The bad news, however, is that building new capacity to produce the basic materials in such short supply can't be done overnight. We're talking about developing iron and copper mines (after exploration companies have discovered the new deposits). About drilling for oil in deeper and deeper water -- or in politically more and more unstable countries. About building new refineries and smelters to turn raw materials into consumable goods. And about constructing docks and pipelines to get these materials to markets. And then there are the really long-term projects -- like liquefied natural-gas terminals -- that will take decades to build, if they get built at all.
Inflation storms in
It's an extra dose of bad news that the Hurricane Katrina disaster -- and the damage still to be calculated from Rita -- will cut supply, in the case of oil and natural gas, and increase demand, in the case of cement and copper, in many of these already tight basic markets for basic materials. This hurricane season has been a major inflationary event at a time when the global economy could have done very well without one, thank you.
And there is absolutely nothing that the Fed can do about this supply-led inflation. In fact, traditional inflation-fighting tools such as raising interest rates, to the extent that they make it harder and more expensive for companies to raise capital for these kinds of supply-increasing projects, may actually increase inflation.
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