Bernanke is Swatting at a Deflation Windmill
Chief among them, the Federal Reserve, much like Don Quixote’s assault on animated windmills, continues to attack
this imaginary deflation foe.
Supporting the Fed’s hand-wringing and angst, Fed Chief Ben Bernanke points to a core consumer price index (CPI) that climbed at its slowest pace since 1966, or just under 1 percent over the past year. Unfortunately, it is inflation and prices bubbles, in my judgment, that jeopardize U.S. economic progress, not deflation.
Remember that the CPI is the price gauge for a market basket of goods purchased by an average urban consumer. Much like the drunk with one hand in the refrigerator and the other in the fireplace, everything is on average “OK.” That is, averages are masking price bubbles and troubling trends in certain areas. For example, over the past year, education prices climbed by 4.8 percent and medical costs expanded by 3.3 percent.
Furthermore, with the CPI overweighting housing, pullbacks in housing prices are producing a CPI that is not representative of this bubbling brew of inflationary pressures that once underway become very, very difficult to slow or halt. A second and more sinister outcome is an asset bubble, or an extended period of time, in which selected assets are overvalued. Investors replace the adage “buy low, sell high,” with “buy high, sell higher.”
Under the guidance of Bernanke, the U.S. central bank has lowered the federal funds rate from 5.25 percent in June 2006 to the current level of close to zero percent. This aggressive and record rate-cutting has contributed to gold prices soaring by more than 98 percent and 10-year U.S. Treasury bond prices skyrocketing by approximately 42 percent since the Fed embarked on this rate slashing. These and other bubbles will burst with very negative consequences unless the Fed begins immediately to increase interest rates.
Each month since 1994, we at Creighton University have been surveying supply managers in nine Mid-America States, covering 800 companies stretching from North Dakota and Minnesota in the north to Arkansas and Oklahoma in the South (www.outlook-economic.com ). These supply managers provide an early warning regarding economic conditions, both regionally and nationally.
Recently, the inflation gauge from this survey has been pointing to elevated inflation in the months ahead. According to my statistical analysis of this and other data, the CPI will rise by 1.2 percent over the next six months (see statistical analysis at www.economictrends.blogspot.com). This higher CPI will increase rates that investors demand from borrowing and it will force the Fed to begin raising short-term interest rates.
How can investors protect themselves against higher interest rates resulting from higher inflation? One way is to purchase an exchange traded fund that takes short positions against the U.S. Treasury bonds. Simply stated, these ETFs increase in value as interest rates increase. Another method is to purchase Treasury Inflation Protected Securities. These debt instruments provide protection against losses from inflation as reflected in the CPI. Finally, for those companies and individuals that can obtain loans, borrow today’s more expensive dollars, and pay back with tomorrow’s cheaper dollars.
In 2008 Congressional Testimony, Democrats and Republicans blamed former Fed “maestro” Greenspan for keeping rates too low for too long, thus inflating the housing bubble. But Greenspan—by holding the funds rate at a lofty 1 percent from June 2003 to June 2004, was a paragon of pecuniary prudence compared to Bernanke. Has Bernanke multiplied Greenspan’s error times four by reducing the funds rate to between 0 and 0.25 percent?
President Reagan once warned that one should never confuse the reviews with the box office. Those in the political class that are currently congratulating Bernanke for his guidance of the economy will be hurling blame when inflation moves upward and asset bubbles burst in the near term. 
Ernie Goss holds the MacAllister Chair of Economics at Creighton University on Omaha.
P | 402.280.4757
E | ernieg@creighton.edu
Return to Ingram's July 2010