Investment XYZ

Tuesday, June 06, 2006

Inflation: Phantom of the Fed?

Twice in a row, confusing "hawkish" words from the mouth of Fed Chairman Bernanke railed the market. First was in May 1 2006 when he spoke to CNBC anchor Maria Bartiromo that "investors had misinterpreted his recent congressional remarks as an indication the Fed was nearly done raising rates." The moment that his remarks hit the wire, the investors immediate got into action to misinterpret the misinterpretation and the market took a quick dive. Bernanke later regretted his "lapse of judgment". The second time was in June 5, speaking at a rare conference of the three central bankers of US, EU and Japanese. Together with the literally incomprehensible English language of Jean-Claude Trichet of ECB and Japanese Deputy Governor Toshiro Muto, the clearly spoken but murky in meaning language by Bernanke sent the stock market into another dive. Dow Jones Industrial Average was down nearly 200 points to the year's low.

Did the market "misinterpret" his words again? Or is the crash more of a judgment of investor confidence on Bernanke himself, rather than just the interest rate? After all, if it were just based on the interest rate, the bond market has already priced in more than a 50% chance of another 1/4 point rate hike in next Fed meeting since the last hike in May 10. Now such a chance would be close to 80% -- an increase, but hardly a surprise.

Let's step back and see how this chain of thought originates. The logic seems simple: what the Fed is concerned about is inflation. If the economy is too good, it causes inflation. To fight inflation, the Fed has to raise the interest rate; in general there is an inverse relationship between the interest rate and equity prices because investors are more likely to sell stocks and put the money in the bank, thus explaining the dive of the stock market. The chain of relations seems to very straightforward, so straightforward that the media picks it up, packages it as a sound bite and propagates it without any questions.

Inflation and Money Supply

First of all, what is inflation anyway? Inflation is defined as "the fall in the purchasing power of a money (i.e., a currency of a country)". Such a seemingly simple definition entails many extensions, particularly when it comes to how to measure inflation. In general there are two camps of thoughts: monetary supply vs price index:

1. Inflation is intrinsically related to money supply. However, that now is being called the "classical theory" of inflation measurement, implying there is a new theory -- which it seems Mr Bernanke happens to belong to (see next item). In this classical theory, if the government prints too much paper money, or there is too much liquidity (outstanding credits) in the banks, the purchasing power is decreased, thus causing inflation.

Money supply measured by the Fed is made up of 3 parts: 1) printed money in circulation, measured in M0; 2) Bank accounts (saving/checking/CD under $100K/money market), measured in M1 and M2; 3) All other CDs, Eurodollar deposits and repurchase agreements (repos, or just call it "glorified pawn shops" for easy understanding), recorded in M3. Two interesting observations: 1) credit issued by the banks are not included in any of the measurements. With the ever prevailing use of credit cards in place of cash, this missing piece in the money supply can be substantial; 2) The items included only in M3 are all biggies.

Interestingly, the US Fed stopped publishing M3 data, the broadest money supply data, on March 23, 2006. It seems with so much focus on inflation recently, that such event should deserve a huge spotlight and analysis. Nevertheless, there is little media coverage of this event, feeding some conspiracy theory that the Fed has something (bad) to hide. In any cases, if Bernanke is not an academian that is concerned with defending some theory (such as discrediting the "classic" money supply theory), shouldn't he, as the Fed chief hawkish on inflation, release or have some openness on the M3 data? After all, money supply is the source of inflation just by the definition of inflation.

Inflation and Prices

2. Inflation is related to prices, which leads to the so-called "Neo-Keynesians" theory. In this theory, inflation is measured by the price changes of a large number of selected goods and services in the economy. However, not all the relative price changes are the same, and their relationship with each other are far from uniformed or straightforward. In general, there are 4 kinds of goods and services that have quite different implications for inflation:

1) Goods for measurement of money, such as a gold and silver. Historically due to the physical characteristics and the limited accessibility of such heavy metals, they are natural carriers of values and were effective in preventing government from printing too much money -- until the end of Bretton Woods System in the 70s. Today, such goods are used as safe heaven against inflation, but hardly a true measure of purchasing power of money, especially gold which has little economic value than its safe heaven value.

2) Goods and services directly related to living. The prices of such a category are the "cost of living", which certainly impacts the consumers. The inflation in this price category would be most apparent for ordinary people.

3) Capital goods and services. The prices of this category impact directly on the business and economic cycles, the purchases of these goods and services are general recycled back into the economy as the increase in productivities and increase in values. If the economic activities are overheating, capital prices will have inflation. But for consumers, they may not directly feel such inflation on the capital cost. For example, if raw material prices increase, the increase in prices will be passed on to the consumers, thus there is inflation in the cost of living. On the other hand, if a company pays a premium to purchase a set of new machines to improve the productivity of manufacturing some consumer goods, the inflation impact on the consumers can be either way: if the company pass the capital cost into the prices of the produced goods, consumers will feels the inflation; however if the productivity and quality increase is so great due to the new machinery so that the prices of produced goods decrease, consumers will feel nothing or even see deflation.

The consistent increase in US productivity in recent decades, as well as the continuous supply of cheap manufactured products from China (which are purchased in the "capital goods" category and resold into the "consumer goods" category) indicate that there is an inverse relationship between the inflation in the cost of living vs the inflation in capital cost. With the factor in raw material costs, the total relationship is far from straightforward.

4) Labor. Labor cost straddles the cost of living and cost of capital categories. On one hand, increased labor costs put more money in consumers' hands, which may let consumers feel deflation rather than inflation. On the other hand, an increase in labor costs may make the cost of produced goods higher. However, just as with the case of capital costs, depending on the increase in productivity and quality accompanying the rise of labor costs, the impact on the consumers can be inflationary or deflationary, or nothing. One good example is China. In the past 30 years after the economic reform, the labor costs have increased by multiples of hundreds or thousands times (measured in terms of average salary), the inflation is relatively in check. The reasons are obvious: productivity jumps, quality of goods leaps, and the availability and choices of consumers goods increase tremendously. All these expand the horizon of consumer goods and services and keep the inflation at a modest pace, while at the same time creating more and more consumers.

Interest Rate

So how does the interest rate get into the picture? In all the above categories there is no mention of interest rates at all. Monetary supply includes the money printed by the Fed as well as credits issued by private banks. Thus in theory interest rate can be used as a lever to pull to control the money supply, and consequently the inflation.

Here is an heuristic way to explain how the interest rate would impact prices and ultimately inflation: 1) an increase in the interest rate makes the US dollar more attractive for cash investors, so that more dollars are purchased and decreases the printed money in circulation, thus reduce inflation. However, in this regard, one of the important measurements, the Eurodollar deposit (i.e., investors use of Eurodollar to purchase US dollars) as contained only in the M3 is no longer published by the Fed. 2) rate increase would reduce consumer credits, so that less consumer borrowing will cause price increases in consumer goods and services; 3) similarly, rate increases would increase the cost of business borrowing, so that slow down the business activities, thus reducing the upward price pressure for capital goods and services.

However, except for the first point, the relationship of a rate increase to the overall inflation is far from simple and linear. If the consumers mostly do not borrow to consume, the second point is less relevant to inflation; and increases in capital costs may not lead to increases in living costs, as we explained earlier that the relationship may work either way. Thus the net effect on the combination of second and third points indicates that it is not straightforward to assume that an increased rate will shoot down inflation. However, from the Fed's statements, they seems to link the faster pace of the economy with inflation (thus they want to choke off GDP growth if it is too high). Under the Fed's microscope, fast economic growth is a sin that needs to be stamped out.

Back to Normalcy, not Weaponry

In the economic world, too much of something is bad, so it is an accepted truth that too fast an economic development is not a good thing and need to be balanced. In a capitalist world, all these excesses have a way of balancing themselves out through the invisible hand. However, the Fed seems to be willingly playing a very visible hand to "adjust" the economy using a wrench of a single interest rate, based on a theory or a model. In a true capitalist world, the government should be the last one to play the role of the invisible hand. Actually the government is just one of the parties in this increasingly complex economic fabric. For the Fed to play a fair role, they should behave just like a good corporate citizen: control well the monetary supply (which is no one else's job except the Fed), and be open about it. The interest rate that the Fed can adjust, the Fed fund rate, which is no more than the rate that banks charge each other for overnight loans, is actually part of a much bigger financial world that should be self-adjusting just like other parts of the economic world. It is not a tool for the Fed to "fight" inflation, as the media sound bites indicate.

So why would Bernanke run around talking about inflation, overheating economy, and appearing hawkish while on the other hand ignoring or intentionally avoiding the Fed's duty of the money printing function and being open about it? There are many theories regarding the relationship of interest rates and inflations, but considering the complex world of interest rates (just look at how many theoretical interest rate yield curve models are out there) and price relationship among cost of living, cost of capital, cost of labor etc., wielding the interest rate stick as a willing weapon seems like a typical fight between scholars on the campus green, rather than a responsible government agency should do with the world's money. Is that possible Bernanke suffers from the typical academic disease that holding a theory as the truth and willing to fight tooth and nail to defend it?

Overnight interbank lending rate is one of the Fed's duties, just as is the duty of controlling the monetary supply. The current string of 16 rate hikes to 5% is the result of the artificially low rate (as low as 1%) to stimulate the economy at the time of the market crisis in 1998 to 2001. That is an example of using the Fed rate as a visible hand to move the economy by Bernanke's predecessor. There are good reasons (or excuses) for that when the market was in turmoil. Now the economy and the market are seems back on track. The Fed should slowly restore the rate to a normal level (as it has done so far since the Fed started increasing the rate in 2004). Bernanke and his Fed colleagues should tell the world that the string of rate hikes is to restore the rate to a normal level, rather than pretending that the Fed rate is an invisible hand they can move around to capture the ghost they release.

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