Inflation and the Hierarchy of Needs

Not to be outdone by Maslow, inflation has its own hierarchy of needs. Basic needs (physical survival) correlate to food and energy, safety (comfort) correlates to core inflation, and self-actualization correlates to asset inflation. The Federal Reserve admits that it has little influence on food and energy, believes that it can control core inflation, and says that it has no control over asset inflation.

I believe the Fed’s rhetoric is only partially truthful. I agree that the Fed has little control over the demand for survival needs. However, when it comes to core inflation (the safety teddy) General Electric (GE), Intel (INTC) and US Steel (X) have more influence on the overall price structure than the Fed.

The Fed is being outright disingenuous when it comes to asset inflation. This form of self-actualization is at the top of the inflation hierarchy of needs. Asset purchases are the most discretionary and the first place for excess liquidity to flow to. While professing the opposite, the Fed has maintained an active policy of promoting asset inflation.

After leaving office, former Fed Chairman Greenspan admitted that the Fed engineered asset bubbles to promote innovation. Even though the housing bust has proved much more difficult than Greenspan had imagined, Fed Chairman Bernanke has not changed policy. Every one of Bernanke’s “specialized” programs has failed to generate targeted core inflation because the Fed cannot really control the application of liquidity, only the intensity of the flow.

The Fed cannot even control which asset sectors get inflated. While the effort to inflate housing prices is failing, stock and even junk bond prices are rising. The question is does the Fed care about targeting asset sectors or just creating a general wealth effect? I believe the Fed’s focus is primarily on managing the overall wealth effect, not inflation in general and least of all the value of the dollar in foreign exchange.

Now we know that both Greenspan and Bernanke have reached self-actualization in the world of asset bubbles. Greenspan’s recent interview with Bloomberg’s Al Hunt was quite telling. He thought the banks could not make a profit and lend efficiently if they were required to maintain capital for long tail events. The role of government is to bailout black swans. Again, the Fed’s policy is to remove any obstacles to asset inflation.

Imprudent lending is Fed policy and that is why Bernanke is so opposed to the creation of an independent consumer protection agency. Protecting consumers from aggressive banking directly stands in the way of promoting the wealth effect. Both Greenspan and Bernanke aspire to see masses of self-actualized consumers.

Regardless of what you think of how inflation is calculated with “owner equivalent rent” and “hedonic” (constant value) adjustments, leaving asset inflation out of the calculation makes the inflation numbers meaningless. Don’t let the Fed tell us that we have no inflation when stocks are up 50% and the dollar is collapsing.

Finally, I am waiting for the Fed to explain in behavioral terms how businesses and consumers changed with each decrease in the fed funds rate. Was the change from 1% to 0% as effective as the change from 5% to 4%?

Wall Street Weather’s "Asset Inflation: The Missing Indicator In Economic And Monetary Policy" provides an excellent discussion of asset inflation and monetary policy.

Disclosure: Author is long GE and INTC.

Comments

[JG Savoldi:]

Interesting that you'd write--"Finally, I am waiting for the Fed to explain in behavioral terms how businesses and consumers changed with each decrease in the fed funds rate. Was the change from 1% to 0% as effective as the change from 5% to 4%?"

Behavioral analysis is what led to our belief that bubbles occur due to leverage not interest rate levels. Leverage is what creates monster bubbles in the first place because it is in essence the fuel that drives the wildfire of speculation. People have the ability to survive investment mistakes of all varieties so long as they have the "staying power" to stick with the position. It's only when outrageous leverage is employed--such as zero down interest only mortgages--that small decreases in the value of an asset can lead to a snow-ball effect and subsequent avalanche of defaults.

It amazing me that we continue to talk about interest rate levels creating bubbles when leverage is the only "rope" investors have ever used to hang themselves.

We first wrote about this dynamic in our 2006 report titled "How to Identify a Speculative Bubble." If you're interested in reading more about this idea you can get a free copy at our website. baminvestor.com

Oct 19 07:57 AM

[User 353732:]

1. Bubbles often result from the toxic combination of massive misallocation of resources, the madness of avaricious and vain crowds and sustained deception practiced by insiders. Bubbles are a disease of finance that metastasizes into an epidemic.

2. Useful innovation often results from adversity, brilliant individual or small group insight, perseverance despite repeated failure and a regard for truth. Bubbles do not foster innovation but it is common for an innovation to be falsely portrayed or the timing and scale of its benefits to be grossly misrepresented to initiate a bubble.
All bubbles are a small truth inside a vast lie. A technological, infrastructure, or financial emerging truth i.e. an infant innovation ,in the dirty hands of WashDC ,Wall St and Big Media can be the small truth around which layers of increasingly extravagant lies are wrapped to engineer and inflate a bubble.
In 2009, the truths have become very small indeed while the lies have become gargantuan.

Oct 19 08:00 AM

[markfl:]

Steinberg wrote:
"The Federal Reserve admits that it has little influence on food and energy, believes that it can control core inflation, and says that it has no control over asset inflation."

If at this late hour the Fed/FOMC truly do not comprehend that an irresponsible Fed Funds rate created the housing bubble (house/asset price inflation), they need their heads examined.

Oct 19 08:21 AM

[Leftfield:]

Krugman recently wrote that the best economists go to academia, the bottom of the class, to Wall St. Makes no sense, of course, but a special place in hell belongs to economists in government. I remain amazed how a field of study can have the appearance of scientific rigor, with graphs and mathematics, and pretense of understanding human behavior, and yet 98% of it's members act or are, clueless about what's in front of them every time. They act primarily as a front for power.
Not only are assets inflated and not counted, but I don't see them mentioning much about the frozen wealth in them that can no longer be used as collateral by our massively subsidized, increasingly useless financial sector. Like government spending, increasingly COUNTERproductive, they miss enough pieces of the puzzle they study to miss the basic picture. And, if the Fed is targeting the overall wealth effect as the article suggests, and that leaves assets inflated to the moon, not much will be left for anything else. This decline of living standards has gone on for a long time already, but economists and our leaders don't know or care. Or, it serves the interests in power.
We have a record concentration of wealth and power, accumulated in exclusion of all else except self-glorification and perpetuated by whatever lies and means are necessary. Blinders are everywhere, willingly worn by the average citizen who appears bent on awakening only when it's too late.

Oct 19 08:35 AM

[Moon Kil Woong:]

Alan Greenspan never denied that he didn't create a housing bubble nor that he couldn't pop it. Rather he said when he was in office that it didn't mattr and he didn't see why there had to be traditional economic cycles at all. If anyone said such things besides the head of the Fed we would have called them an uneducated loon and sent them back to take rudementary economics.

To say that the Fed can't control asset inflation is a disingenuous lie. But Bernake is quite good at spewing so many lies we just stop paying attention. Like take for example the fact he said he adored Greenspan until he was villified. Then he said Greenspan caused bubbles by keeping interest rates too low for too long yet he is keeping interest rates even lower even longer and claims there is no bubbles (certainly not in the dollar). His recent threats, claims about tightening have been dismissed by the market as has his speech 9 months ago about protectibg the value of the dollar with strong dollar policies.

The author is right, we must fact the fact everything we buy overseas is getting more expensive and the only things deflating is our income and the value of our US dollar based assets. The wise ones stopped believing the Feds lies months ago. That's why there is such a big rush into commodities and a steep fall off of the dollar. The market has spoken. Now we get to see what new lies Bernake can spin. They get less effective every day. I assume that's the law of diminishing returns. I guess that law holds true to even for lies.

Oct 19 08:42 AM

[The Geoffster:]

Nothing a return to the gold standard wouldn't cure.

Oct 19 09:22 AM

[damienhaas:]

"The role of government is to bailout black swans. Again, the Fed’s policy is to remove any obstacles to asset inflation."

The government will bailed out banking sectors when they cause one of the serious financial crisis in the modern era and the Fed then help removal of obstacles i.e pump up the stocks price so that Goldman Sach and JP Morgan can benefit.

Oct 19 09:35 AM

[CautiousInv...:]

1) That there is relationship between bubbles and innovation is absurd; if the innovation carries value, bubbles should not be allowed to implode. I would argue twisted innovations lead to bubbles which is different than saying bubbles foster innovation.

2) Bubbles be definition are an over allocation of resources to one or more asset groups leading to an unsustainable increase in prices. As the author suggests, the Fed simply provides the liquidity and controls the intensity of the flow sluicing into the asset categories. It is, however, most convenient we have a bubble today that confers a fairly broad based wealth effect. A suspicious person could be forgiven for thinking it was engineered.

3) If banks cannot be profitable while simultaneously being prepared for a fat tail event, the business model is inherently flawed and they should either rework the model or be allowed to fail upon the event.

Oct 19 10:12 AM

[twotraps:]

Interesting article. Does this mean that bond yields can move higher on their own? The fed assures everyone they will keep the policy rate low to help the economy but in reality the cost of money will start rising whenever it wants....that could get interesting in a hurry.

Oct 19 10:13 AM

[Dave Wrixon:]

Interesting concept and to me at least novel.

However, it is clear that Feds real intent is to game the markets until the fictitious valuations on the Banks' balance sheets gain some credibility, so that it can withdraw at least some of the support it has given without hearing that terrible sucking noise.

Oct 19 11:39 AM

[jimmy46:]

The FED has a problem trying to control the economy with interest rates.
Productive borrowers, ie business's looking to expand,
or people looking to buy a home to live in,
are very sensitive to increasing interest rates.

Speculators on the other hand,
are very much less affected,
in their mind, their speculation is going to make
50% or more in a year, so who cares about the difference
between a 5% and 6% interest rate?

Can the FED set different rates for speculators?
I don't think so.

Oct 19 02:27 PM

[zorrow:]

I have a question. How can I invest in the dollar? I don't consider currency speculation investing. Psychologically, I feel more comfortable looking at visible earnings. Hence I will invest in international companies like MCD and INTC. What the dollar's relation is to other currencies doesn't bother me psychologically in the least. I think this is because it is an accounting of group action as opposed to anything that meaningfully affects any individual investor (other than currency speculators).

Oct 19 03:41 PM

[ebworthen:]

Well, you either bring the girls into the bar with cheap drinks on ladies night, or you have strippers and charge $6 a beer and make sure they keep drinking. That is...if you are running a seedy bar versus a water treatment plant.

Oct 19 07:56 PM

[bob adamson:]

Regardless of what you think of how inflation is calculated with “owner equivalent rent” and “hedonic” (constant value) adjustments, leaving asset inflation out of the calculation makes the inflation numbers meaningless. Don’t let the Fed tell us that we have no inflation when stocks are up 50% and the dollar is collapsing.

Nov 18 02:12 AM

[bob adamson:]

Sorry, my earlier post should have read as follows:

Mr. Steinberg, in your article on October 19th you state:
“Regardless of what you think of how inflation is calculated with “owner equivalent rent” and “hedonic” (constant value) adjustments, leaving asset inflation out of the calculation makes the inflation numbers meaningless. Don’t let the Fed tell us that we have no inflation when stocks are up 50% and the dollar is collapsing.”
Over the past two years both the average value of stocks and the value of the US dollar have changed dramatically; often in opposite directions. Arguably it is reasonable to assume that the surge in the exchange rate value of the US dollar in the 4th Qt of 2008 and 1st Qt of 2009 and the corresponding plunge in stock prices reflected both a flight to quality and a fear of possible deflation. They do not reflect actual deflation of a significant or lasting nature at that time however. Doesn’t it follow that the recent retreat in the exchange rate of the US dollar and surge in stock prices simply represent both a relaxation of the earlier fear of deflation and some fear of possible inflation at some time in the near future? Isn’t it also somewhat misleading to imply that “stocks are up 50%” represents an inflationary trend when an increase from the exceptional and short-lived lows of February of 2009 might more accurately be largely accounted for as a relief rally? Further, what are we to make of the stock market highs of 2006 in the context of this discussion?

Nov 18 02:14 AM