Best of DOUG NOLAND

Good Inflation?:

"And the essential fact right now is that the American economy needs an inflation rate above the Fed’s comfort zone." Paul McCulley, "A Kind Word for Inflation", June 16, 2008

I have elevated the status of my old "analytical nemesis" to that of the most dangerous monetary analyst in the country. He has been preaching inflationism for years now, and the more obvious the flaws in his framework the more creative he becomes in crafting his sermons. And he’s become so adept at this game that many might actually buy into his flawed yet seductive logic.

Essentially, if I am reading McCulley correctly, he is arguing that because of an unusual "trade shock" from rapidly escalating energy costs, the Fed must employ negative real interest rates to avoid a "modern day depression." I will continue to espouse the view that today’s ridiculously low interest rates are part of the problem rather than the solution.

Back in 2001/2002, the Inflationists were keen to monetize the wreckage from the technology bust through the inflation of mortgage Credit. Not uncharacteristically from a historical perspective, this inflation ran out of control and amuck. Now, with much greater and generalized financial and economic post-Bubble wreckage, the unbowed Inflationists are subscribing more generalized consumer price inflation as part of the medicine to ensure asset prices and the real economy avoid sinking into a deflationary spiral.

A book could be written explaining why the Inflationists are so wrong. This evening I’m limited to the briefest synopsis.

Today’s inflationary forces have been developing over a period of many years. Importantly, the key dynamic is one of a highly unusual strain of acute global inflation. The impetus for this inflationary backdrop has been the massive inflation of dollar financial claims, in particular a Bubble in Wall Street asset-based lending that spawned unprecedented distortions to both the U.S. Credit system and underlying "Bubble economy" (and, increasingly, the global economy). This massive dollar Credit inflation ("currency" debasement) opened Pandora’s Box for similar unfettered expansions in domestic Credit systems across the globe.

Oil is inarguably the most important commodity in the world. The massive ongoing inflation in energy prices is and will continue to have momentous economic, financial, and geopolitical consequences. Comparisons to the seventies and seventies-style inflation, however, miss key aspects of today’s inflationary dilemma.

There are three interrelated dynamics that are driving current inflationary forces. First, there is the massive flow of dollar liquidity inundating the world. Despite huge dollar devaluation, a major Credit crisis, and economic downturn, our system is on track for yet another year of $700bn plus Current Account Deficits (and this doesn’t include the massive speculative outflows to participate in the global inflation). Global economies, especially booming Asia, are awash in dollar liquidity to use to bid up the prices of oil and other strategic resources. Second, today’s massive dollar flows have increasingly gravitating to speculative endeavors (hedge funds, sovereign wealth funds, commodities speculation, etc.) – each year ballooning the "global pool of speculative finance" that by its very nature chases rising prices ("liquidity loves inflation"). Third, the confluence of the flood of global liquidity and unfettered domestic Credit systems has exerted its greatest stimulatory effect upon the highly populated countries of China, India, and Asia generally. This, then, has created a historic inflationary bias throughout the energy, food and commodities complexes.

McCulley and others prefer to "monetize" the current oil price "shock" through ongoing artificially low interest rates, arguing that recent price effects are a temporary phenomenon. This short-term jump in inflation is said to be, in the words of Mr. McCulley, "Good Inflation." Supposedly, it will help buttress the general prices level and generally help support asset prices, while tepid wage growth ensures that a 70’s-style wage price inflationary spiral will be avoided. Yet such analysis seems oblivious to the nature of the underlying risks associated with the current inflation.

As should be obvious by now, the current hyper-inflation in energy and food prices risks global chaos. There is today such a robust inflationary bias in globally priced necessities that spectacular (NASDAQ1999) price moves have become the norm rather than the exception. As such, U.S. monetary policy that accommodates $700bn Current Account Deficits and massive speculative outflows to the world is courting Monetary Disorder Disaster. To be sure, the current trajectory of U.S. financial outflows ensures an acute inflation problem for key things everyone wants and needs. Or written differently, efforts to "monetize" mortgage losses and energy inflation here at home will be invalidated by a global push to exchange excess dollar (and other currencies) liquidity for real things of necessity and tangible value.

A major flaw in the "Good Inflation" argument is that surging fuel, food and other costs in reality are administering a further crippling blow to the over-indebted U.S. consumer. Grossly inappropriate short-term U.S. interest-rates are today directly stoking serious price inflation, in the process reducing consumer discretionary incomes and the capacity to service enormous debt loads. The collapse in SUV and truck prices (see Bursting Bubble Economy Watch) – and the resulting huge "negative equity" in auto loans - is the most obvious example of household sector creditworthiness taking a direct inflationary hit. This has created a major additional burden for millions that bought the big new home out in suburbia. And because of the worsening Credit backdrop, mortgage and consumer debt borrowing costs are rising in spite of Fed rate cuts. Moreover, households are suffering further from the sharp reduction in returns on their savings, not to mention the inflation-related decline in many stock prices.

The seventies inflation saw consumer prices rise, incomes rise, home and asset prices rise, and wage-based inflation spiral higher. The current inflation dynamic is a different beast. Sinking home prices and surging energy and food prices are causing bloody havoc on general creditworthiness, a huge dilemma for the faltering financial sector and the finance/consumption-driven Bubble economy. The bust in Wall Street finance is driving a major shift in economy-wide spending patterns, putting downward pressure on wages, incomes and profits in some sectors, while other sectors enjoy huge inflationary boosts. The breakdown in Wall Street "alchemy" has ensured that this round of Fed-orchestrated reflation bypasses home prices as it hastens problematic inflation elsewhere. A very strong case can be made that the nature of the Wall Street finance and asset-based lending boom nurtured a degree of financial and economic imbalance and vulnerability unlike the wage-based inflation of the seventies.

And while headline inflation numbers today may not be approaching the 70’s double-digits rates, I would argue that an even more problematic economic adjustment is in the offing. I simply see no way around the necessity of sharply reducing the amount of new Credit and imports required to sustain the U.S. economy. I see no alternative than a long and wrenching adjustment period while the household balance sheet is repaired, financial sector stability is restored, and some semblance of economic balance is achieved. Students of the sordid history of massive inflations are familiar with the inevitable pleas for just a little bit more inflation and a little more and a then lot more… McCulley wants us to believe the Fed is doing the right thing by providing us some "Good Inflation." This really upsets me. I’ve repeated over a number of years a lesson learned repeatedly throughout history: Inflationism is a "Road to Ruin." This road has become all too visible.

Doug Noland is a market strategist at Prudent Bear Funds. Their website is www.prudentbear.com.