Is Inflation a Serious Risk?
If you read the Wall Street Journal or watch the financial news, you will likely see stories stating that the Fed is not concerned about inflation, since, as our economy cools, there will be less pressure on the prices of commodities such as oil and food. These articles imply that the recent reduction in oil prices is a good example of why inflation is not a significant concern.
However, from July 2007 to July 2008, the Consumer Price Index (CPI-U) was up 5.6%, the highest in 17 years, oil is 75% higher than it was in 2007 and the dollar is down 10% against the Euro in 2008. From my perspective, the reason that the Fed is ignoring inflation is that, while maintaining a Fed funds rate of 2% and increasing the US dollar money supply, they are willing to trade the risk of high inflation against the risk of collapse of major US financial institutions. These, of course, are the same financial institutions which created the current financial crisis.
I do not have enough data, nor am I wise enough to evaluate the risk of failure of our financial services institutions. I will trust that this data and wisdom resides in the Fed and that they have made a calculated decision to create an inflationary environment in order to minimize the risk of financial institutional failure. However, regardless of their reasons, the Fed policies are destined to increase inflationary pressures.
In today’s financial environment, there are several reasons why low interest rates are beneficial to financial institutions. Two examples include:
1. Adjustable rate mortgages are often tied to the Fed funds rate. A low Fed funds rate helps keep payments on adjustable rate mortgages low. While in ordinary times this might not be in a bank’s best interest, in today’s mortgage marketplace, maintaining the current 2% Fed funds rate may help decrease the number of mortgage defaults by keeping the adjustable mortgage payments lower
2. Lending institutions typically pay depositors interest that is based on short term interest rates, while the interest they receive on loans is often based on longer term rates. Lending institutions can maximize profits when there is a significant difference, as there is today, between short term interest rates and longer term interest rates.
Unless the Fed radically changes course, the US could repeat the hyper inflation of the 70s. At this point, there is no commitment by the Fed to address their current inflation stimuli. Until this changes, my plan is to remain “invested for inflation.” Our past experience has demonstrated that once inflation is imbedded in our financial systems, it will likely take years before it can be lowered. Let’s hope that the Fed takes action to correct this situation, before it is too late.