Forecast Inflation: January 2008

Inflation

One of the darkest downside risks to the economic future is a Fed which overreacts to inflation. Inflation is inevitable with the fall of the dollar. Dollar decline has arrived in a long-delayed response to economic fundamentals, particularly the decades of enormous trade deficits. The decline will be resisted by those invested in the greenback as a reserve currency, by those who depend on American markets for their own production, and by the Fed, which views inflation as a stand-alone phenomenon which is determined by monetary policy.

The fall of the dollar means rising prices because of globalization. Prices for imported manufactures will rise from nations who do not manipulate their currencies. Prices for imported commodities will rise in direct proportion to the dollars fall plus a premium for speculation. Manufactures and commodities that are domestically produced will also rise in price to the extent they are bid up by overseas consumers.

Given these rise in relative prices, a healthy economic program would be to allow wages to adjust upward as well. This the Fed will not do. Panicked by rising prices, the Fed will attempt to suppress inflation as it has done over the past three decades, by suppressing wages. Its "core inflation" indicator is a proxy for compensation to workers. It is quite likely the Fed will actually raise rates even in the context of economic downturn.

Resisting Fed tightening will be the financial sector and markets who need a seemingly unending supply of cheap money to dissolve the obstacles that arise in the absence of rational regulation. Financial markets will pause, however,when they see the value of the dollar deteriorating here at home, because the perceived value of the long-term bonds they are holding for security will decline. It is likely the Fed will be able to enlist many of these bond-holders with its alarm and the claim that tighter money will preserve the value of these long-term dollar-denominated securities.

This portion of the forecast is in large part not analysis of economics, but psychoanalysis of economic actors, including the Fed and the herd actors of the markets. We have assumed only a slight rise in the federal funds rate, but no action approaching the great Volcker Monetarist debacle of the late 1970s and early 1980s.

Forecast Recession: October 2007

We are already in recession. Issued (October 25, 2007)

The various prognosticators trying to see over the horizon by jumping up and down on their statistical trampolines will not get the official word for another three months. But without housing employment, the US would have been in at best a stagcession over the past three years. Now there is no housing employment, and the consumer spending derived from home equity is gone.

Inflation is guaranteed by the bidding up of commodity prices and the flip side, the falling dollar. Very likely the Fed will panic again, this time to the upside. The same matrons screaming at their husbands during the credit crunch will be screaming just as loud for rate hikes when they see their dollars eroded by the very cut they demanded in the first place.

(Beware, I have learned my lesson, and I'm not calling for a precipitous drop in the dollar that would be indicated by the fundamentals, just the current slide. There are plenty of players with powerful positions who will do all they can to stem the tide. They may be successful for as long as eighteen months.)

Recession and Inflation

Crisis will be deepened by Fed action.