The battle against inflation has begun, and you better take heed because U.S. interest rates will likely start rising. Federal Reserve Board chairman Ben Bernanke's statement last week was clear and explicit, and it as much as said the Fed will fight inflation and protect the dollar - which means raising rates - as much as is needed. How much is that? More than you think.
That inflation is high and rising is an open secret. That the government's inflation numbers - the consumer price index - are a joke, is also an open secret. Bill Gross, the renowned U.S. bond manager, calls it "inflation excluding inflation," because the figure does not include gas and food prices. However, if you eat and drive, your family's grocery bill has probably risen 10 per cent during the last year, and your driving cost has risen by about double that rate. Prices everywhere are on the rise - except home prices.
This accelerating inflation in the teeth of a weakening economy is a huge problem for the Fed, because when it starts raising rates - as it practically just promised - the U.S. economy can tank, and because the U.S. economy is 28 per cent of the world's, this will likely sink the world economy alongside.
The problem is so acute because to quench inflation this time, the Fed may have to raise rates more than usual because today's inflation is not the same as yesterday's, and its explanation is different, too.
The first classical explanation of inflation is that too much demand is chasing too few goods and services. The modern believers in this theory think that pension funds and institutions who invest in commodities drive up their prices. To alleviate inflation, such believers want to come down on commodity-investors, seeing them as "hoarders."
The other, so-called "monetarist" explanation is that excessive money-printing causes inflation. The Fed usually subscribes to this view, so to reduce inflation the Fed would print less money, or raise interest rates.
But has too much money really been printed? The U.S. money supply has been somewhat stagnant, despite recent Fed largesse. So where did inflation come from?
Well, there is a third view based on research done at Stanford University some years ago - a modern twist on the monetarist view: Yes, inflation is a result of the amount of money in circulation. But the highlight is on "circulation."
Here I must get a bit technical: Money supply is the monetary base times the velocity of money. The first is how many dollar bills and dollar deposits are in circulation. But the latter is how many times each dollar (virtual or physical) circulates in a year.
The Fed can control the first - but it cannot control the second. And it's this last part that keeps rising because of technology - which is why inflation keeps getting harder to control by classical (interest-rate) means, and why this round of rate hikes may be steeper and longer than most think.
You see, 50 years ago a dollar bill changed hands perhaps four or five times a year. Then, when business began to be done by credit cards, this rate increased dramatically. And today, when many individuals and corporations pay their bills online, where payments are super-fast, the velocity of money has soared yet again. So even if the Fed withdraws some monetary base, it is that second part of the equation that today matters most. Furthermore, that research also showed that once money velocity approaches instantaneous, the money supply tends toward the infinite. And how can the Fed control that?
In a word, it can't. When the same monetary base sloshes around faster and faster, it has the effect of a much larger monetary base of years ago. So even when the Fed starts raising rates, the ongoing acceleration of payments would negate much of its action.
The proof is in the type of inflation we see today - it is not the classical kind which spills into everything at once. Rather, it is a series of bubbles.
Because today's money is mainly electronic, it can move on a mouse click. But like all money, it is hungry for a return. But because there are not that many opportunities, this electronic money latches on to anything with a credible story and moves fast into the new category. This movement starts the category moving - which causes more hot money to slosh into it - which in turn causes Wall Street to satisfy the money-slosh by generating more product.
The most recent such bubble was subprime mortgages, which were sliced and diced and packaged, then traded electronically - until they crashed. Now we are seeing the beginning of a commodity bubble.The Fed has just said it will fight this bubble - via interest rate hikes. I believe the Fed, and so should you. If you own bonds, I would go for shorter maturities. If you borrow money, lock in rates. Tomorrow's rates will most certainly be higher. What it will likely do to the stock market I'll leave to your imagination.