Inflation Is On The Rise

This is the first time I've written on the home page about the markets or the economy in a year and a half. In June 2005, I wrote about the high debt levels in this country and how that was going to be a problem over the next 20 years. Click here to read that. When a government is in debt, and its leaders lack the politicial will to cut spending, debt and inflation go hand in hand. Inflation is creeping up.

First, I want to take a step back, and do some tidying-up. In early May, when the stock market first reached 13,400, I predicted money markets would out-perform stocks the rest of the year, and stocks were likely to be down from that point. Both of those predictions turned out to be correct. From early May to the close of December 31, money markets earned about 2.5%. During that time the Dow declined a bit, closing the year at 13,264 or down 1%. Not a big winner, but taking small winners will never bankrupt you, so you take them where you can.

There were a lot of reasons I turned negative on US stocks. One was the length of the economic expansion and another was rising inflation. I was surprised stocks hung in as well as they did. I truly expected the Dow to be down 5% to 10% from early May to the end of the year.

What I underestimated was the US government’s willingness to stimulate the economy, in the face of rising inflation and the economy being at full employment. Here we are, at full employment, inflation is heading up and the US government is in full stimulus mode, and pressing harder on the gas. The Fed is cutting interest rates. The Congress is running a big deficit. The US Treasury pushing the dollar down. Fifteen, and even ten years ago, that would not have been the case. Government leaders had a healthy fear of inflation back then.

It has been nearly 30 years since we’ve had an inflation problem in the US, and I’m afraid many in the US Congress, at the Treasury and the Federal Reserve have forgotten or don’t know what it is like to have inflation. Our leaders no longer fear inflation. When a country forgets the lessons of history, it repeats history, and I’m afraid that is what is going to happen here.

Oil has doubled over the past three years. Wheat doubled in value this past year -- have you looked at your grocery bill lately?. Copper has doubled over the past two years. Naturally, Gold, the inflation barometer, has doubled in value over the past year and a half.

The inflation rate has risen from 1.6% in 2002 to 4.3% in 2007. Will it go higher? Yes. That’s my prediction, and it is mainly because the people running the Fed, Congress and the US Treasury no longer respect inflation.

The US government faces two problems. Its large government budget deficit (the US government spends more than it brings in, and borrows the difference), and the large trade deficit (the US imports more than it exports). Both the budget deficit and the trade deficit are related. The budget deficit causes the US government to borrow a lot. That pushes up interest rates and the relatively high US interest rates causes the dollar to be more attractive to foreign investors. That higher dollar, however, makes US exports relatively expensive and causes imports to be cheaper in price, hence it causes the trade deficit.

The economics 101 solution is for the US government to cut spending and balance its budget. That will reduce government borrowing; interests will then fall, making the dollar less attractive, the dollar will fall and exports and imports will come back into line. That is, the government and trade deficit will disappear, and the fix will be non-inflationary, because falling government spending will help to offset the economic stimulus of lower rates and a falling dollar.

Our leaders in Washington don’t have the political will to fix the trade deficit correctly, because they don't have the will to cut government spending. Instead, they go for the forced fix, by having the Fed cut interest rates and the Treasury pressuring foreign countries in order to get the dollar down and their currency up. Here’s an example of that with China. Click Here.

Pushing rates down and forcing the dollar down, without cutting government spending, all of this simulates the economy. Given we are at full employment, this will raise the inflation rate further in my opinion.

I like my prediction of Gold going to $1,500. It make take a few years to get there, but I think it is heading in that direction. I think gasoline is going to $4. That’s more of a function of world economic growth, and the problems in the middle east, but it will add to the inflation level.

On the bright side, with all this government stimulus, the economy is likely to avoid a recession. Thus, everyone will continue to work, but their pay checks will not go as far. And sooner or later, if inflation continues to rise, the government will have to shut down the economy in order to cool inflation. That’s usually a messy affair (1979 13% inflation, and in 1981 we had 21% interest rates and 13% unemployment in 1982). My hope is the government will slow its stimulus before it gets that bad and such a dose of medicine is required.