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Fed Finds Inflation, Flips Inflection, Mystifies Masses
(March 23, 2005) On Tuesday, the Federal Reserve Bank, as expected, raised the federal funds rate by a quarter-point, its seventh such move since mid-2004. But a subtle change in verbiage threw the stock, bond, foreign exchange and precious metals markets into a tizzy.
In short, a lot can hinge on a few words in a Fed statement. This Tuesday, the Fed for the first time in four years recognized that “pressures on inflation have picked up and pricing power is more evident.”

This is basically Fedspeak for “We will finally acknowledge the possibility of inflation, even though our recent history has shown us to be blind to such a phenomenon, and despite what we will call mere anecdotal evidence of galloping price increases experienced by consumers, manufacturers, drivers, flyers, shippers, builders, importers, and mere mortals everywhere. And maybe later - not now - but keep an eye on us, though, because we might raise short-term rates 50 basis points instead of our usual 25 basis points, in an attempt to squelch an inflation that has become so overwhelming that yes, even we will admit that it might exist.”

As Greg Ip noted in his article “Fed Lifts Rates, Warns on Inflation” in the 3/23 Wall Street Journal, “For the past year, however, Fed officials believe that the U.S. has been at “price stability” – a zone where inflation, at about 1.5% by their preferred measure, doesn’t figure significantly in companies’ or households decisions.”

Thus Mr. Ip correctly asserts that the Fed, by utilizing their ‘preferred measure’ of inflation:

a) Doesn’t believe that we have any inflation in excess of, say, what banks pay on savings accounts, and,

b) Believes that you and I share that benign assessment.

As to b), let's try to see it the Fed's way. We'll simply stipulate that the Fed is right: all evidence of inflation is simply anecdotal. We see prices going up on everything, we share those perceptions with others, we tut-tut about it – but in doing so, we’re obviously misinformed citizens, merely trafficking in hearsay, ignorant of the hedonic calculations that only the Fed is privy to, the statistics which show that prices are rising…about 1.5% annually.

But, as the Economist points out in an article in its March 17th-25th issue, “Wide Gap, Wide Yawn,” perhaps the Fed is asleep at the switch:

“Central bankers are paid to worry. But top officials at America’s Federal Reserve appear quite relaxed about the country’s current-account deficit, just as it hits a new record. According to figures released on March 16th, the deficit widened to 6.3% of GDP in the fourth quarter of 2004. To sustain it for a year, America would have to borrow a net $750 billion.”

To simplify this big number and render it more understandable, let’s take this sum (¾ of a trillion dollars) and divide it among the approximately 100 million workers in the US not employed by the government, just to see what each worker’s share of that deficit is.

Ready? Have you figured it out already? Well, time’s up - in more ways than one. The current accounts deficit works out to $7,500 per US private sector worker. If you are one of that crowd, that’s what you’re borrowing at the current pace PER YEAR above and beyond your other mortgage, consumer, or loan-shark indebtedness.

That’s about $30 per working day being added to your debt load just for being an American working citizen. Scary, eh?

For the gold-centric among us, this week’s overdue admission by the Fed that inflation is not just an obsolete concept from the 1970s seemed like it would be a spur to the gold market. Of course, in the complex scenario of Fed manipulation of the price and supply of money, that assumption would be incorrect. Instead, the dollar surged, breaking a weeks-long sinking spell, stocks sank, and bonds tumbled. Also, gold fell.

Why? Well, higher interest rates are a boon to the dollar, attracting investors. A stronger dollar means cheaper gold. Rising yields means bonds sink in price. Higher interest rates can slow down the economy. A slower economy can be counter-inflationary, and therefore a negative for gold, which is a hedge against inflation.

Is any of that clear? Not to me, either. Personally, I get a headache just trying to figure it all out.

If we weren’t so busy shoveling gold out the door and into the hands of the growing number of people who feel this is a grand buying opportunity, I would take a day off just to ponder the economic verities in hope of a broader, truer wisdom.

Preferably on a bright, sunny Arizona day, with a spring training game in front of me.

-Richard Smith


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