Monday, September 22, 2008

The inflation trade is back with a vengeance

The market is still worried about how the Paulson/Frank bailout plan will actually work and how it will affect the economy. I'm still wondering myself, and it's hard to find anything to cheer about, except that one way or another the government is going to be socializing the costs of the housing crisis. This will take pressure off of the financial sector and should lead to an unclogging of the financial system over time. The great unknown is just how bad this precedent will be for the future of our free market system, as the government plays an ever-greater role in financial markets.

Meanwhile, the concerns about inflation have really heated up in the past two trading days. A weaker dollar, soaring gold and oil prices, and rising breakeven spreads on TIPS are all signs that the market is getting more worried now about inflation. The Fed has been plenty easy, in my view (though other supply siders, most notably Art Laffer would disagree), and they still are, so it's no surprise to see this.

The actions in dollar, gold and oil all suggest that the problem we're facing is not one of a shortage of dollars. Dollars are plentiful and cheap, why else would the value of the dollar be declining against these three key benchmarks?

If there is plenty of money in the system, then it's likely that the economy won't be as bad as many people seem to fear. Inflation is not good for an economy, since it leads to malinvestments (like the housing boom) that then need to be worked off and result in lost productivity. But we're not in a hyperinflation were everything is paralyzed. So I'm still optimistic that we're going to avoid an economic collapse or a deflation as some are predicting. The surprise will likely be that the economy continues to grow, albeit modestly, and inflation continues to be a problem. Should this be the case, look for Treasury yields to rise significantly, and all other yields to rise by much less.


egp said...

am I right in assuming that this is the first time you are saying "The Fed has been plenty easy"? :)

My two cents:
The FED was easy under Clinton, leading to the stockmarket rally in 1999.

After the Stock market crash in 2000 and Sept11 the FED was easy again, leading to the housing bubble.

And now the FED is easy again after the hosing crash.

What else can an institution like the FED do than print money? Boom-bust-boom-bust-....

Scott Grannis said...

In earlier posts on this site and in my professional writings dating back to early 2003, I have argued that the Fed was too easy and this was creating rising inflation pressures. This also contributed to the housing bubble.

Before that, I argued repeatedly in the 1996-2000 period that the Fed was too tight.

CDLIC said...

The following article (9-12-08)titled 'Last Gasp of a Doomed Currencyis' from the website Financial Sense University at
It supports your position regarding inflation returning with a vengence. Here is a paragraph from the article.

"When the dust settles, the Federal government will be left with staggering liabilities that will be impossible to repay with legitimate means (taxation or borrowing). To make good, they must rely on the printing press to create money out of thin air. The rapid expansion in money supply will push the dollar down mercilessly."