Bernanke’s Little Problem

This article appeared in Forbes, July 3, 2006.

At forst glance the 2001-03 plunge in U.S. interest rates seemed to have delivered the goods:Growth in output and employment slowly accelerated,and inflation stayed within the FederalReserve’s comfort zone, under 2%. However, bymid‐​2004 the Fed realized that the rate of inflation was creepingup after bottoming out in 2003. And so it slowly but steadilyratcheted up the short‐​term cost of money. The overnight moneyrate is back up to 5%. The screw‐​tightening is not necessarilyover. At least that’s how Wall Street read Fed Chairman BenBernanke’s June 5 warning about prices.

The Fed’s standard line is that it looks at all indicators ofinflation. That said, it’s no secret that the Fed’s preferred inflationgauge is the “core” measure for Personal Consumption Expenditures.This gauge, which tracks what people spend broadly(except for food and energy), over the past year has risen by only2.1%. While this rate exceeds the Fed’s informal target of 2%, it isstill low enough for the Fed to claim that inflation is contained.However, other inflation measures challenge that benign characterization.The PCE that includes food and energy, for example,has increased by 3% in the past year. The Consumer Price Index,based on a fixed basket of goods and services (energy and foodincluded), is up 3.6%.

Moreover, there are good reasons to believe that the government’sprice indexes, with or without the volatile food and energycomponents, are sending out artificially weak inflation signals.For example, the recent boom in housing prices doesn’t evenshow up in the CPI. Something called “owner’s equivalent rent” isused as a proxy for the cost of homeownership. This metric hasnot kept pace with house prices.

If we look at real market data, such as that generated by commoditymarkets, the inflation picture changes dramatically. Overthe past year the price of gold is up by 51% andcrude oil by 35%. Indexes that include marketclearingprices for a broad range of industrial and agricultural commodities are also up sharply. The CommodityResearch Bureau’s index of 23 commodities is up 15% from ayear ago. Whether we look at government statistics or marketprices, it’s pretty clear that the Fed pushed on the money‐​creditaccelerator too hard and for too long.

As I mentioned in my Dec. 8, 2003 column, governmentstatistics, like the PCE and CPI, lag behind changes in commodityprices. Accordingly, I expect further increases in the government’sinflation metrics and more Fed tightening. If you didn’tfollow the investment advice in that column, do so now: Dumpyour conventional bonds and replace them with Treasury inflation‐​protected securities (Tips). Put 10% of yourportfolio in commodities, gold being an ideal choice.

Excessively low interest rates and excess credithave generated other distortions and imbalances.Those schooled in the business cycle models developedby Friedrich Hayek in the 1930s know thatexcessively low interest rates result in a widening gapbetween savings and investment. People are unwillingto postpone consumptionif the return to savings is meager,and users of capital are tooprone to finance borderlineprojects when the cost ofmoney is low. Sure enough,gross savings was 16.7% ofgross national product in 2000.

By 2005 it had fallen to 13.8%of GNP. Gross investment (that’sinvestment before a deduction forcapital consumption) as a percentof GNP held its own during thisperiod, starting at 20.7% andending at 20%. Consequently,the savings‐​investment gapballooned from ‑4.0% of GNP to‑6.25%.

At the national level, that savings minus investment in theU.S. is equal to U.S. net foreign investment. And this is equal tothe balance on the U.S. current account, which is broadly thedifference between U.S. exports and imports. If domestic investmentexceeds total savings by Americans, as it now does, importswill be greater than exports, and we will acquire foreign capital tofinance the difference. In simpler terms, our increasing tradedeficit is a function of the negative differential between oursaving and investment rates.

The politicos, predictably, blame the Chinese for our tradedeficit. And why not? What American politician has ever lost anelection by blaming foreigners for a problem made in the U.S.A.?Expect more China bashing, more mercantilist policies and anincreasingly vulnerable dollar.