Don't Underestimate the USA

Max Whitmore: Inflation? Who Said Inflation?!

The Fed did their thing last week and there was a torrent of words from every corner of the globe about how they had: (1) done exactly the wrong thing; (2) done exactly the right thing; (3) went weak-kneed and gave in to Wall Street; (4) Wall Street failed to get the Fed to do its bidding; (5) Bernanke is a rooky and is making rookie mistakes; (6) Bernanke did a brilliant job; . . . and on and on!!

The only sure thing most agreed on was that the Fed took action to get the confidence of the investing and banking business and to overtly assure the investing public that it was ready to do whatever was required to make sure that the country did not experience undue hardships and possibly a recession. (Bernanke believes that recession is the outcome of bad management, not an inevitable economic outcome no one can control.)

Today, seeking to apply every available tool of good management, the Fed uses just about every type of high-tech computer program available (and many programmed by their own staff) to “run scenarios” that help predict recession or other undesirable economic outcomes if no preventative action is taken today.

Then, a study of these undesirable outcomes is made to see just what different types of present actions “plugged in” to the program might help prevent or mitigate these undesirable outcomes down the road. This computer “looking forward” study helps the Fed to zero in on just what the best action might be today.

It is from these “looking forward scenarios” that the action on the Sept. 18 was framed. The FOMC statement alludes to just this technique. For example, here are some of the key phrases of the FOMC statement of Sept. 18: “Today’s action is intended to help forestall some of the adverse effects on the broader economy that might otherwise arise from the disruptions in financial markets and to promote moderate growth over time.”

I believe it was the use of the above mentioned computer programs that led the FOMC to lower rates as much as they did. I do not recall any time in the previous 18 years of the Greenspan Fed that the steps taken were to “forestall” disruptions, as was clearly noted in the FOMC statement.”

Note that the phrase “to promote moderate growth over time” was spelled out, too. In my opinion, this was to salve the frayed nerves of investors worldwide. I think it also was to address the inevitable inflation questions.

The FOMC statement then directly addressed inflation in the next paragraph, again in my opinion, to pre-empt criticism some would level at it as a result of the drop in rates. They said: “Readings on core inflation have improved modestly this year. However, the Committee judges that some inflation risks remain, and it will continue to monitor inflation developments carefully. ….The Committee will continue to assess the effects of these and other developments on economic prospects and will act as needed to foster price stability and sustainable economic growth.”

They obviously felt it was necessary to cite the moderation of core inflation to clearly tie the reduction of rates to the goal of promotion of long-term growth. But, they also added that they would be “carefully” monitoring the situation regarding inflation “to foster price stability“. To me this paragraph really was the basic purpose of the entire FOMC statement. It is inflation that now has everyone on pins and needles!

I find it most interesting that inflation is the one outcome that everyone seems to expect. I think I would be fairly accurate if I said that ALL the articles I have read addressing the FOMC action are unanimous in predicting or fearing that inflation was the next outcome. There can be no other outcome they believe. Well, I don’t believe those predictions for a minute. The last thing that usually happens is what everyone expects — the last thing!!

In my view, this is akin to the world believing that interest rates rule the world’s economic health. I have said over and over that it isn’t interest rates, it is money supply. Read my last 3-4 articles again and you will see why.

Basically, because Bernanke’s research papers and essays about the Great Depression — research covering periods as far back as the 1890s — over and over clearly spells this out.

Additionally, he also points out on page 250-51 of his book “Essays on The Great Depression” his take on inflation. In his words, “Theory suggests instead that inflation will be determined by current and expected money supply and demand.” This statement is made as part of an argument about unemployment in the Depression, but clearly again makes the case that control of the money supply is a better control device that any other for inflation.

My own view on this matter goes to a simpler way of stating the situation. Inflation due to a lower value of currency — a condition typically precipitated not by actual conditions but by fear — requires (1) that import levels remain the same, but at higher prices and that (2) internal production capacity of the country is either at or very close to full capacity or that the ability to produce goods to replace the higher cost imports (but at a more competitive price than the imports) is lacking for any variety of reasons.

My own expectations are that imports will substantially moderate in the next 12 months. U.S. buyers of imported goods will find it more competitive to buy USA goods instead of imports. This condition will exist, in my opinion, because this country is a sleeping giant, as Admiral Yamamato of Japan, once observed. If you wake it, it will beat you at every turn.

I see this country going on a production binge not seen in many years. I look for exports to soar, production for our own consumption to flourish, and for the huge foreign investments made by many U.S. companies to become the proverbial albatross about their necks.

I have no way of knowing if Bernanke senses this same scenario, but I would be surprised if he didn’t. The loss of hundreds of billions, several trillions, of our sovereign wealth over the last 30 years occurred because we let it occur.

As a nation, we did not, primarily for political reasons, combat the unfair positioning of many nations against us on the economic playing field. These countries set their currencies — especially China — well below our dollar and used low paid sweat labor to produce goods to sell to our nation at prices we just could not match under such circumstances.

Now, the lower dollar is biting our competitors back in a big way. To continue selling to us, they must sell production at a loss, as the peg of their currencies to our dollar now is having negative consequences for their economy. How long will they do that?

That depends on how serious they think we are in fighting back. We have just seen the biggest increase in U. S. exports in decades during the past 19 months. For the first seven months of 2007 (August numbers not included yet) the U.S. is running at an annual rate of $1.6 trillion (annualized) in exports, versus an annual rate of $1.44 trillion in 2006 (Jan-July 2006 $822 billion vs. Jan-July 2007 $915 billion). That is a handsome +11 percent increase over last year and with the dollar favoring us even more in world markets recently, I expect we might even challenge the +14-15 percent gain year-over-year. (Source of data is U.S. Census Bureau, Foreign Trade Div.).

All this export increase means more and bigger paychecks landing in U.S. households. Now add to this higher income from what I think will be a huge increase in U. S. production for U.S. consumption — at prices better than those offered by imports — and I just don’t see inflation. Instead, I see healthy economic expansion, likely well above our long-term rate of expansion of 3.5 — 4 percent per year.

To have inflation, we would need (1) a Fed not keyed on “carefully” watching inflation and using money supply to moderate it — but our Fed is “carefully” watching — and you need (2) an American business community that passes up the golden opportunity of competing with imports on its own home turf (and winning this time) — but, that too, will never happen!!

Will I be right? I think so. But, I expect that the argument will rage on for the next 6-10 months as investors start an “inflation watch” and slowly come to the realization that the stock market has it right so far.

Stock index prices are climbing and not because of anything except an overall investor consensus that the Fed is right on target. To me my Super Chart Keyline now becomes the front line of this terrific battle. I will be watching it with baited breath. It should be a fascinating few months!