Inflation is rising and real rates are falling

July producer prices rose more than expected, both at the core (0.4% vs. 0.2%) and total (0.2% vs. 0.1%) level. Producer price inflation has now been trending irregularly higher for almost 10 years, after trending irregularly lower throughout the 1990s. Over the past six months, the core PPI has increased at a 3.6% annualized rate, a level that was exceeded only once (in early 2008) in the past 20 years. Inflation is definitely alive and well.

These next two charts focus on the behavior of inflation and interest rates. Over long periods, inflation is the main determinant of interest rates, but over shorter intervals of as much as several years, interest rates and inflation can diverge, with interest rates tending to lag changes in inflation. Monetary policy is typically an important contributor to this divergence.

For example, currently the Fed is bent on keeping interest rates as low as possible, presumably in order to help stimulate the economy and to avoid the risk of deflation. The Fed's accommodative monetary policy stance can "fool" the bond market for awhile, especially since both the Fed and the bond market believe that inflation fundamentals have a lot to do with the strength or weakness of the economy. The economy is perceived to be so weak today that both the Fed and the bond market believe that even though inflation is rising, there is little risk that it will continue to do so.

But the divergence between interest rates and inflation can also serve to amplify the effects of monetary policy. When interest rates are substantially lower than inflation, as they are today (see third chart above), then investors, speculators, and corporations discover that it can be very profitable to borrow cheap money and buy "things" that are rising in price. Negative real interest rates thus encourage people to borrow more and more and speculate on rising prices, and the Fed is more than happy to accommodate this rise in the demand for borrowed money.

Just the opposite happened throughout most of the 1980s and 1990s. The Fed wanted inflation to fall, so it tightened monetary conditions by keeping interest rates high. Borrowing costs were much higher than the rate of return on the prices of "things," and over time this punished borrowers and eventually caused the demand for borrowed money to decline. Money gained new respect, and the demand for money increased. The dollar strengthened and commodity prices fell, and inflation proved to be low and relatively stable.

The confluence of forces today is much more reminiscent of the inflationary 1970s than of the low-inflation 80s and 90s. And it's quite simple in fact to determine whether inflation is likely to rise or to fall. All you need to know is whether the Fed wants to be accommodative or easy, and whether the Fed's professed policy stance is confirmed by real interest rates. Today there is almost no doubt that the Fed wants to be accommodative, and real interest rates confirm that, since they are substantially negative. Thus we can predict that inflation is likely to continue to trend higher in the next several years.

Borrowing money at today's exceptionally low interest is consequently likely to prove profitable. And as more and more people discover this, and the demand for money declines (increased demand for borrowing money is equivalent to a reduced demand to own money), then the dollar will tend to lose value and the prices of "things" will tend to rise. The gold market is well aware of that, and has likely priced in a lot of this already.

This is all very unfortunate, of course, since what is being fueled by all this is not a stronger or healthier economy, but a more speculative economy with higher inflation. A speculative economy is not a healthy economy, since speculation does not tend to produce productive things. Indeed, speculation leads to bubbles and the misallocation of resources, and over time this can be very inefficient and squander scarce resources. Thus it is that, instead of being "stimulative," the Fed's current monetary policy stance is acting to slow the economy's growth.

Meanwhile, the Bernanke Fed has put its reputation on the line by promising to keep short-term interest rates exceptionally low for at least the next two years. If the above analysis is correct, it won't be too long (another year?) before they are forced to change course and tighten policy, at great cost to their credibility and to the purchasing power of the dollar.

Why is it so hard for Washington to understand that the combination of easy money and fiscal spending stimulus is not at all a prescription for growth? A weak economy is the predictable outcome of easy money and too much spending. Instead of being even easier and more "stimulative," policy should emulate the combination that produced strong growth and a strong dollar in the 1980s and 1990s. Monetary policy should be focused on strengthening, not weakening the dollar. Fiscal policy should be focused on increasing the incentives for the private sector to work and invest and take risk—by lowering and flattening tax rates and eliminating tax preferences—not on spending more. Fiscal policy also needs to focus on radically reforming entitlement programs, which will otherwise grow like Topsy and skew incentives towards less work, less investment, and more idleness.