Wednesday, January 05, 2005

The US stock markets sold off sharply yesterday amidst fears that inflation is bubbling to the surface. Price data didn't spook them. Instead it was the Fed's analysis of price data which send them scurrying back to their holes.
U.S. financial markets sold off late Tuesday after the Federal Open Market Committee revealed it is seriously divided over the prospects for inflation.

The FOMC was roughly split into two camps on the outlook for inflation at their closed-door meeting on Dec. 14, according a summary of the meeting released Tuesday.

Although the faction that insists that inflation is under control won out at the December meeting, the minutes showed a number of the U.S. central bankers on the committee were growing worried that the weaker dollar, higher energy prices and a slowdown in productivity growth could lead to higher prices.

They saw signs that the prolonged period of low interest rates was leading to bubble-style behavior and "excessive risk-taking," such as "quite narrow credit spreads, a pickup in initial public offerings, an upturn in mergers and acquisition activity and anecdotal reports that speculative demands were becoming apparent in the markets for single-family homes and condominiums."
Two-speed inflation is the name of the game these days. The combination of globalization and loose monetary policy from the major players (esp. US and Japan) means:
  1. outright deflation in most tradable goods and services -- for example, nominal durable goods prices (PCE index) in the US are -19% since early 1995, and clothing and shoes are -13% over the same period;

  2. runaway inflation in assets, especially housing.
It seems the Federal Reserve is today more or less where the Bank of England was a year ago. Back in January 2004 the BoE repo rate stood at 3.75%, just beginning its steady climb to today's 4.75%. UK consumer inflation was and has been well under control, running consistently below 2.0%. However, asset prices -- especially housing -- were spiralling out of control. So the BoE upped rates with an eye to deflating the housing bubble.

The inflation "hawks" at the Fed are staring at much larger housing bubbles across much of the US, particularly California, Nevada, Florida and the Northeast. The inflation "doves" on the other hand are looking at low job growth and consumer prices and see nothing to worry about.

This dichotomy is precisely what one expects to see under conditions of commodity and financial globalization, particularly in a country like the US which can attract capital under almost any condition (stress on almost). The real question is whether the Fed thinks asset inflation is growing out of control and is likely to crash abruptly -- and whether a Fed tightening might burst the bubble itself.

Interest rates are one hell of a blunt hammer to use when attempting to work on a myriad of economic fixer-upper projects. But as the old saying goes, when all you've got is a hammer, suddenly all problems start looking like nails.


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