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Why Inflation Would Be Another Drag On The Economy!

  • Written by Syndicated Publisher No Comments Comments
    June 22, 2014

    When the Fed wants to stimulate a stagnant economy, or pull one out of a recession, its first tool is to cut interest rates via the Fed Funds rate.

    And when it wants to cool off an over-heated economy it raises interest rates.

    In first pulling the economy out of the 2001 recession, then trying to encourage spending after the 2001 terrorist attacks, and more recently trying to pull the economy out of the Great Recession, it kept cutting interest rates until it had them down to the current unprecedented near zero level.

    With the rate near zero, and the economy still weak and anemic it cannot cut rates further. But it can, and has, assured us that it will keep rates at “the current exceptionally low level” well after it has finished tapering back QE, implying sometime toward the middle of next year, perhaps even longer.

    But now has come the potential that inflation has begun to rise.

    Easy money policies in the past have almost always resulted in rising inflation, and doomsday pundits have been predicting for 14 years that the extreme easy money policies in place since 2001 would create extreme inflation. However, inflation has been totally absent – until recently.

    With the increases in inflation as measured by the CPI and PPI over recent months, which has CPI inflation now at 2.1% for the last 12 months, concerns about inflation are rising.

    What’s wrong with inflation rising? Nothing if it rises only fractionally. In fact, a little inflation is thought to be good for the economy. The Fed has set its comfort level at 2% for many decades.

    However, if the rise from 1% roughly a year ago to 2.1% is the beginning of a new upward trend it would be a problem for even a strong economy, but much more so for an anemic economy.

    Why? Because rising inflation has the same effect as if the Fed were raising interest rates to cool off the economy. It decreases the buying power of wages and income.

    For instance, in the report that the CPI had jumped again in May, with the core rate rising 0.3%, it was also noted that real wages, that is wages adjusted for inflation, had declined0.2% for the month. A decline in the buying power of wages makes it more difficult for consumers to help spend the economy out of its doldrums – whether that decline in buying power is due to rising interest rates or rising inflation.

    We’ve already seen an example in the housing industry, where the recovery stalled and has worsened since home prices and mortgage rates began rising a year ago.

    We don’t need to see the same result from rising inflation in the broad economy.

    Yet, the still rising price of oil, gasoline, food, etc., raises the possibility.

    Rising inflation in an anemic economy, so-called stagflation, is the Fed’s worst nightmare,because, as the old saying goes, once inflation is out of the bottle it’s difficult to get it back under control.

    The most recent occurrence of rising inflation while the economy was still weak, was in the 1970’s. Not wanting to risk the weak economy, the Fed was slow to respond to the rising inflation by raising interest rates. Inflation and interest rates soon spiraled up into double-digits, with terrible results.

    FROM Investopedia: “The easy-money policies of the American central bank, which were designed to generate full employment, by the early 1970s also caused high inflation. The central bank later reversed its policies, eventually having to raise interest rates to some 20%, a number once considered to be usury. For interest-sensitive industries, such as housing and cars, rising interest rates caused a calamity. With interest rates skyrocketing, many people were priced out of new cars and homes. The stock market was a mess. It lost 40% in an 18-month period, and for close to a decade few people wanted anything to do with stocks. Economic growth was weak, which resulted in rising unemployment that eventually also reached double-digits. ”

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    Does this have a familiar ring?

    Investopedia also says, “The gruesome story of the great inflation of the 1970s began in late 1972 and didn’t end until the early 1980s.  . . . . . Many Americans had been awed by the temporarily low unemployment of 1972. . . . . . The great inflation was blamed on oil prices, currency speculators, and greedy businessmen. However, it is clear that monetary policies, whichfinanced huge budget deficits and were supported by political leaders, were the cause. . . . . . It began in 1969 with a president facing re-election. Nixon inherited a recession from Lyndon Johnson, who had simultaneously spent generously on the Great Society and the Vietnam War. Congress, despite some protests, went along with Nixon and continued to fund the war, and increased social welfare spending. . . . . . A new Fed chairman was appointed in 1971, Arthur Burns, and the President (Nixon) was reported to have told him, ‘We’ll take inflation if necessary, but we can’t take unemployment’. As a result, the nation soon had an abundance of both.”

    So you can see why the possibility of inflation beginning to rise could be a cause for concern, given the similar political as well as economic similarities, especially after this week’s FOMC meeting, with the Fed (and a new Chairman) blowing off CPI inflation being up 2.1% for the last year as just “noise”, saying that it must concentrate on employment.

    That said, 2.1% inflation is not a problem. It becomes a problem only if it continues to rise.

    So one thing we can be sure of.

    Whereas analysts have been focused on interest rates, and when the Fed might eventually begin raising them from zero back to normal levels, and markets have been encouraged by the Fed’s promise to keep rates near zero for a long time yet, that focus on interest rate promises is going to now shift to inflation reports, that other factor that cuts into the spending power of consumers and businesses.

    So far, the stock market does not seem to care, with investor sentiment at high levels of confidence in the Fed, and complacency.

    However, in another similarity to 1973, there are warnings from so-called smart money (insider selling, high level of IPO’s, warnings from the likes of George Soros, etc) that are being ignored.

    Interestingly, as I outlined in my 1999 book ‘Riding the Bear – How to Prosper in the Coming Bear Market’, a 39 year-old Warren Buffett, pulled off one of the most exquisite market-timing moves ever seen. He closed out all the holdings in his investment fund in 1969, closed the fund, and returned the cash to his investors, telling them they would be better off in safe government bonds for the next several years. He used some of his own profits to buy textile manufacturer Berkshire Hathaway, which he would subsequently use as the foundation for his next venture when he returned to the stock market. The 1969-91 bear market followed, and then the more serious 1973-74 bear. And in 1974, at the end of the 1973-74 bear market, Buffett did return to the stock market, saying in a famous late 1974 interview in Forbe’s magazine, “This is the time to start investing again.”

    Of course by then, crushed investors who had not listened to his and other warnings as the previous top approached, had no interest.

     

    Another warning from the housing sector?

    Is the weakness in housing spreading into the broad economy?

    Owens Corning (OC) lowered its expectations for 2014 yesterday, blaming it on weakness in its roofing division. The company said the winter weakness in roofing volumes continued in April and May, and it expects the decline in volumes for the first half of 2014 may be as much as 20% below the first half of last year.

    But hey, as I said in a recent column  Worry about the Second Quarter, Q1 is History  noting  the warnings being seen in the economy, market valuations, smart-money activity, etc.:

    The market doesn’t care.

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    Or at least those still piling in while insiders bail out, don’t care.

    To read my weekend newspaper column click here:   Is Stage Set for Markets to Again Be Smarter than the Fed-

    Images: Flickr (licence attribution)

    About The Author – Sy Harding, Street Smart Report

    Sy Harding publishes the financial website Street Smart Report Online and a free daily Internet blog at Sy’s Free Blog. In 1999 he authored Riding The Bear – How To Prosper In the Coming Bear Market. His latest book is Beat the Market the Easy Way! – Proven Seasonal Strategies Double Market’s Performance!

    It includes our research and analysis on the economy and markets, and provides charts and buy and sell signals on the major market indexes, sectors, bonds, gold, individual stocks and etf’s, including short-sales and ‘inverse’ etf’s.

    It provides two model portfolios as guides. One is based on ourSeasonal Timing Strategy, one on our Market-Timing Strategy.

    In depth updates are provided every Wednesday, with interim ‘hotline’ updates every time we make a trade. An 8-page traditional newsletter Street Smart Report is provided on the website every 3 weeks, in pdf format for viewing or printing out.

    There is the Street Smart School of online technical analysis ‘seminars’,commentaries to keep you ‘street smart’ about Wall Street, and much more. 

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