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WSJ Opinoin Piece on Inflation – A Must Read

The Wall Street Journal today has a spot-on article on inflation and how its being encouraged by Fed policy. Its a must read for all of you that think my inflation thesis for investing is all wet…

The Bernanke Reflation
February 29, 2008; Page A16

For readers under age 30 who are wondering why they are suddenly paying $3.15 for gasoline and $2 for milk, the answer is that this is what an inflation looks like. Those of us of a certain age remember it well, if painfully, and judging by the noises coming from the Federal Reserve of late we had all better get used to it again.

First, Fed Vice Chairman Don Kohn declared that, while inflation was worrisome, the Fed now views recession as the more urgent danger to fight. Then on Wednesday, Fed Chairman Ben Bernanke told Congress that the Fed will do whatever it takes to stop the credit squeeze from becoming a recession. That’s about as close as a central banker will get to saying that he’s thrown price stability to the wind. If inflation rises — as it now surely will — then the Fed will worry about that later, after the economy is safely past the credit crunch.

[Ben Bernanke]

Right on cue, the best indicators of inflation expectations hit new highs. Oil has surged past the once astronomical $100 mark and is now $102 a barrel; as recently as September, it was $70. Gold is nearly $975 an ounce, and the $1,000 threshold seems inevitable. The euro has broken $1.50 for the first time, while commodity prices in general are hitting record highs. These increases will roll through the rest of the economy and lift prices for food, energy, and countless other goods and services.

Call it the Bernanke reflation, though it’s more precise to call it the Fed’s second inflation gamble of the decade. The first was Alan Greenspan’s roll of the dice from 2003-2005, keeping interest rates too low for far too long in the aftermath of the dot-com bust. That spurred the first boom in commodity prices, as well as the subsidy for debt that led to the housing bubble and the credit mania whose collapse we are now dealing with. Mr. Bernanke was a Fed Governor during much of that time, and he seems to have learned his lessons all too well. He’s now going all-in for round two.

[The Bernanke Reflation]

Naturally, the Fed and its most vocal constituencies — Wall Street and politicians — see nothing much to worry about. Wall Street sees a reflation as a way to ease its credit problems, as price increases ease debt burdens and perhaps reflate housing values. Congress and the White House see a way to perhaps avoid a near-term recession, which might get them past the election.

As for the Fed, its Governors are dusting off their favorite intellectual justifications. We are told that inflation isn’t as bad as it seems because “core inflation” — which excludes food and energy prices — isn’t rising as fast as the consumer price index. However, food and energy are what most Americans are having to spend ever more of their paycheck to buy. Thus the Bernanke reflation is in part self-refuting even as a short-term recession antidote, because it robs consumers of some of their discretionary income just when the economy needs it.

Meanwhile, even the Phillips Curve is making a comeback. That’s the notion — popular before it was discredited in the 1970s — that there is a trade-off between inflation and economic growth. In its new version, argued by Fed Governor Frederic Mishkin, the Phillips Curve doesn’t exist in the long term but does in the short term. Thus the Fed can afford to open the monetary flood gates now because the slower economy could lead to lower prices later this year. Then when the economy recovers, the Fed can afford to tighten money again.

This is a beguiling intellectual construct, but it puts a great deal of weight on Fed Governors to know when to tighten again. They were supposed to do something similar in 2003-2005, but they were terribly wrong. Then as now they were also dismissing such forward-looking price signals as gold and oil and instead focusing on such misleading indicators as “core inflation” and the money supply. Mr. Mishkin may be seen as a monetary wizard at the Fed, but to investors around the world he is beginning to look more like a high-class inflationist.

The people who aren’t being fooled by all this are the American people. They don’t pay their bills with “core” dollar bills, and they know those dollars buy less with each passing month. This explains their rising economic anxiety — and anger — better than trade or job losses do, especially since the job market has remained relatively healthy. Inflation is the great thief of the middle class, as even Americans who don’t recall the 1970s are learning. With its all-in reflation bet, the Bernanke Fed is gambling with their money.