Thursday, March 19, 2009

Inflation and Bonds

The Fed announced that it is buying long-term bonds in order to drive down the rates. This will have two effects:

The good - lower rates for fixed-term mortgages.

There are three ways to stimulate the economy - reduced interest rates, tax cuts, and increased federal spending. Of these, reduced rates are the most successful. To date, increased federal spending has never worked because it comes too late and is targeted wrong. According to Woodward's book, the Agenda, Paul Volker convinced Bill Clinton early in his presidency that lower interest rates were the best way to solve his recession. Short-term rates are already as low as they can get so the only possible target is long-term rates. This will allow people to refinance their houses and get hundreds of dollars in their pockets. It will probably boost house building.

The bad - inflation.

The government does not have any money to buy these bonds so it is printing new money. This is inflationary. The Fed knows this and is counting on it. The same announcement said that they felt that the current inflation rate was too low to support a recovery. Deflation has been a worry.

Here's where we get into undesirable trade-offs. Inflation started picking up last year. It was triggered by Chinese demand for oil and for copper and steel. This pushed up the prices of manufactured goods. At the same time, Congress mandated an increased amount of corn should be turned into ethanol for fuel. This pushed up the price of corn. It also pushed up the price of other grains as farmers switched to corn. This affected the price of corn-fed meat (beef and chickens) and of products sweetened with corn syrup.

The Fed worried about inflation and pushed the prime rate up. This caused variable rate mortgages to go up. Since a large portion of sub-prime mortgages were variable-rate, this caused the loan-default rate to climb, triggering our current crisis.

This latest is just one of several infusions of cash that the Fed has pushed into the economy. At some point the recession will end and people will start spending that extra cash. This is likely to raise the inflation rate a lot.

At the same time, people's wages are frozen or shrinking. Lots of workers have accepted a cut in wages or at least a freeze. Inflation means that their dollars will not go as far.

As far as I can tell, all of this means that most people's standard of living is going to go down. I don't see any alternative with fixed wages and renewed inflation. I don't expect any relief from the current administration, either. Obama has made it clear that he values fairness over growth.

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