Rising Inflation

Rising Inflation: All Bark and No Bite?
By John Myers


“…At best, the CPI calculation is bad methodology. At its worst, it is downright deception. At a Senate hearing, Democratic Sen. Bob Graham of Florida said that using the CPI to determine inflation was like “using a thermometer to measure distance…”

The talk of Washington, Wall Street and practically every town around the world is something we haven’t heard about for some time: higher interest rates. And when a Federal Reserve chairman flaps his trap about raising those interest rates in Washington, a tsunami of fear sweeps across the globe.

Are we in for higher interest rates? Well, just maybe. Federal Reserve Chairman Alan Greenspan hinted at the prospect when he testified before Congress in late April.

But in early May the Fed voted unanimously to keep the federal funds rate at a 46-year low of 1% and suggested they will raise borrowing costs later to head off inflation. According to Greenspan, the Fed is no longer worried about deflation, but is building a bulwark against future inflation.

Investors are betting Greenspan and his fellow central bankers will begin raising interest rates in quarter-point steps in August. That’s enough to throw the bond market into a tizzy… making some real asset investors more nervous than a prize turkey right before Thanksgiving.

Rising Inflation: Higher Than You Think

The Treasury bond market took it squarely on the chin as the yield on the bellwether 10-year note jumped half a percent, to 4.44%, in less than four weeks. But even with this new higher yield, Treasury bond buyers are not staying even with the new inflation rate – 5% annualized during the first three months of this year, according to the government’s consumer price index (CPI) numbers.

The CPI is calculated by collecting prices each month for 80,000 items. The items are a representative basket of urban consumers’ purchases of food, clothing, shelter, fuel, transportation and medical services at a given point in time.

But the actual inflation rate in the real world is probably higher still. Statistical quirks of the CPI cause it to understate the real rate of inflation.

Rising Inflation: Missing Out On the Truth

One reason that the CPI does not accurately reflect price trends on Main Street is that the fixed market basket is recalculated only once every decade. That means that new items, things like Palm Pilots and MP3 players, don’t get added to the mix. Neither do college tuition costs. Food and housing account for 58% of the total CPI calculation, yet taxes are not included. Certainly most of us pay more in taxes than we do for food and housing.

At best, the CPI calculation is bad methodology. At its worst, it is downright deception. At a Senate hearing, Democratic Sen. Bob Graham of Florida said that using the CPI to determine inflation was like “using a thermometer to measure distance.”

The fact is that the true rate of inflation is much higher than the low CPI number, probably around 6% in our opinion.

That means that 10-year Treasury holders who bought in when the yield was 4% are actually making minus 2% on their money. That might not be such a big deal if it were not for the size of the Treasury bond market. Treasury debt totals $3.5 trillion, making it the federal government’s most important borrowing pool – a pool that cannot be tampered with, even while President Bush insists on keeping tax cuts as the costs of waging war are soaring.

Rising Inflation: Depending on the Kindness of Strangers

More than any time in 50 years, the federal government is dependent on borrowed money – with 40% of total Treasury debt owed to lenders overseas. Since the beginning of 2002, Treasury debt has grown by $500 billion. Of that, foreigners have bought $400 billion worth.

So while the French, Germans and Chinese did not directly support the war against Iraq, they have certainly helped finance it. The problem is that the war has turned into an expensive and bloody occupation of indeterminate length. And there are immediate economic consequences.

The uncertain occupation of Iraq and its 200 billion barrels of oil reserves have driven oil prices close to all-time highs. Since petroleum is used in everything from gasoline to fertilizers, doubling its price will have an unmistakably inflationary impact on the United States and the world.

Rising Inflation: How Much for Peace?

Rising inflation means a decline in the dollar’s purchasing power. Until now, foreign investors have been patient with Washington.

But in 2004 the cracks in America’s armor are beginning to show. It took mere weeks to overthrow Saddam Hussein, but it may take years to successfully mold Iraq into a peaceful nation. With so much already vested in Iraq, and with that nation drenched in oil reserves, the United States cannot afford to walk away from the mess.

But the real question is: will the United States be able to afford to stay in? If so, what will be the cost? Not just the cost in lost lives, but the cost in terms of the nation’s deficit, the purchasing power of the dollar and damage inflicted on the equity and bond markets?

The Baseless Fears Facing the Market

The United States has not had to finance a war and backstop the economy since the days of Lyndon Johnson and his disastrous foray into Vietnam. The result of that guns-and-butter policy was a weakened dollar and rising commodity prices… exactly the trends we’ve witnessed over the last three years.

Yet many commodities gave up some of their gains recently for two reasons: news – or should I say rumors? – on China… and fears that the Fed might tighten interest rates. And both are enough to chase loyal real asset investors away. But as far as I’m concerned, there’s no reason to panic.

Can’t Stop Now

In April Chinese Premier Wen Jiabao said the world’s most populous nation needs to “take effective and very forceful measures” to resolve its economic ills. China, whose demand had fueled rallies in many commodities, faces resurgent inflation due to unchecked expansion in its money supply, bank credit and fixed asset investment. So the talk is China may cut back on its future expansion… at least for now.

But honestly, does that mean China will turn its back on its hunger for copper, silver, gold and other metals? No way. The Chinese have already had a taste of “Western” life. This is their Industrial Revolution, and the Chinese won’t turn away from that now.

The Dogs of Rate Hikes… Bark Over Bite

As for the Fed raising rates… we certainly agree that the next move in the fed funds rate will be up. But I suspect the initial rate hikes will be smaller and more distant than most folks expect. After all, remember an election is coming up in November. The last thing Greenspan wants to do is blow the election for President Bush.

So basically, I think Greenspan’s bark is bigger than his bite. And expect to hear more barking as the year progresses.

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John Myers – son of the great goldbug C.V. Myers – has been helping readers earn suprisingly lucrative returns in stocks largely unknown to Wall Street’s wunderkinder since his early 20s. Our man on the scene in Calgary, John has his fingers on the pulse of natural resource profits – including oil, gas, energy and gold.

John has recently put together a shocking exposé on the unreported turmoil in Saudi Arabia…don’t miss it – the effect on your portfolio could be significant:

Terror in the Oil Market  – A Deadly Threat to the U.S. Economy

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