Rising Inflation, Non Rising Interest Rates: The FOMC Have Their Hands Tied

by: Stock Traders Daily

The FOMC is stuck between a rock and an ''almost hard place'.' The rock is the increasing level of Inflation and the risk of accelerating Inflation. The 'almost hard place' is their inability to raise Interest Rates in the face of it.

In it's policy statement on Wednesday the FOMC disclosed that the concerns about accelerating Interest Rates were at the forefront of their agenda. Here's a direct quote from the FOMC's policy statement: "...the Committee's predominant policy concern remains the risk that Inflation will fail to moderate as expected."

I have since taken the liberty of evaluating just how serious this issue may be, and in doing so I have come to some startling conclusions. (These basis can be found in the numerous charts at the bottom of the page here). The conclusions are clear: the FOMC has their hands tied.

The first step is to evaluate Inflation, so I took a sample directly from the Bureau of Labor Statistics in an effort to gauge increases over time. My initial interest was to find the patterns of wage growth over time to determine if wage growth should be a major concern to increasing prices. The concern, I have found, is not necessarily in the growth of wages, but more so in the lack thereof.

My sample encompassed the period of 2000-2007.

Again, from the BLS, I made further evaluations of the prices of food products and energy in major US cities in an effort to understand the relationship between prices and wages. The study included electricity, natural gas, fuel oil, gasoline, bread, ground chuck, chicken, eggs, apples, oranges, tomatoes, bananas, coffee, concentrate, and lettuce. These are not lifestyle choices, these are necessities. Although these are considered the volatile part of the CPI, these are the things that we must spend money on every month in order to survive.

Clearly looking at these components on a monthly basis can distort the findings of the CPI because these prices can be extremely volatile month-month. However, on a longer term basis, like the one used in this study, the change in prices of these components is very important, and should be closely studied.

The comparisons between 2000-2007 showed me that the prices of these goods and services increased at almost twice the rate of wages during the same timeframe. Wages increased by 17.9% between 2000-2007 (weekly wages nationwide according to BLS). During that same timeframe the prices of these components grew by 37.6% (Data source: BLS). These prices outpaced wages by 110%.

How can prices outpace wages?

No one wants to sacrifice the lifestyles that they have been accustomed to if they have the choice, so if their disposable incomes start to deteriorate in relation to their day-day expenses they will first try to find a way to pay for those added costs before accepting a reduced lifestyle. This is human nature; people are reluctant to move backwards or make sacrifices unless there are compelling reasons to do so.

In the last handful of years there has been very little reason to worry. Even in the wake of the internet debacle, and even in the face of a slumping housing market more recently, the economy still looks healthy, so sentiment remains robust. That positive sentiment makes us believe that we don't need to worry about adverse economic conditions.

This has opened the door for increasing levels of debt in US Households. In fact, very recently the savings rate has turned negative for the first time. This means that US Households were actually pulling money out of their savings instead of adding to it (they would never do this if there were economic concerns unless their hands were forced). In this environment, they are doing this to maintain lifestyle.

The best way to explain the severity of this point is in graphical form. I have taken this graph from yardeni.com. It is 1 year old, but it demonstrates the dichotomy between savings and debt very well. The level of debt is escalating exponentially, while net savings is declining. In essence, we have more debt and less equity because we feel that the economy is unlikely to experience adverse conditions.

housing problem.

Yhis leads us to our next obvious question, a question about debt. Children often do what they see their parents doing, and the same might be true for US citizens in relation to the Federal Government. Our Government is spending money at a much faster pace than it should. In the chart below the total amount of US debt is shown to be accelerating at a much faster pace than the level of income. Really, how long can this last? If you ever wondered why the dollar is weakening, this chart can help you understand why.

natdebt-vs-natincome

Consumers are accepting higher levels of debt to afford the increasing costs of living, and they are not afraid to do so because the cost of money is comparatively low to the early 80's, which most people remember. However, Interest Rates are slightly under historically normal levels. The Fed funds rate has averaged 5.7% since 1955, and it is currently at 5.25%. The FOMC has tried to position itself in such a way as to remain flexible, and according to historical measures, it does have room to move in either direction.

But the FOMC is limited.

Money supply is plentiful, this is evident in the Money supply chart below. The abundance of liquidity has made M&A activity robust, and it has allowed the government and institutions to assume higher and higher levels of debt. Initially this could be construed as a positive thing; influencing economic activity is something that we all consider positive. However, in this case, the ability to control Inflation seems sacrificed.

fed funds

Let's look at both sides of the Interest Rate picture. First, the possibilities of lower Interest Rates: the FOMC could hardly justify lowering Interest Rates in this economic environment. Money is already easy, the economy is healthy, the stock market is at historical highs, and economic activity on a corporate level is robust. Nothing in the current environment, aside from a slump in housing, suggests that the FOMC should or will cut Interest Rates anytime soon.

On the other hand, with the fear that Inflation will not moderate, a bias to increase Interest Rates to control Inflation exists. However, with the extremely high levels of US debt, and with the already slumping housing market, an increase in Interest Rates would devastate the economy.

First of all, the demand for housing is already weak, higher Interest Rates would only further that phenomena, and drive home prices lower. Subprime, in this scenario, would only be the tip of the iceberg. Next, credit card debt, and other non-mortgage related debt: according to the Federal Reserve the percentage of debt burden to income in the US is 25.5% for renters and 18.2% for home owners nationwide on average.

Historically high levels of debt limit the ability of the FOMC to control Interest Rates.

If the FOMC increased Interest Rates by just 50 basis points (to match the historical average) $240 Billion would be taken out of the economy (based on 2006 debt levels). The housing Market would deteriorate even further, the debt/equity levels of US Households would diverge even more than they are now, and the US Economy would face serious economic recession.

The FOMC is caught between a rock and an 'Almost Hard Place,' and that 'Almost Hard Place' if firming up quickly. If Inflation begins to accelerate, the FOMC will face one of the most important decisions in US History: do we let Inflation increase, or raise Interest Rates and face economic recession?

Although new data comes out at the end of this week, the higher than expected level of PPI in the last report could be a sign that eventually prices will begin to rise on the consumer side too. In the face of a slower economy, after all, companies still need to make money; Wall Street is impatient that way. If they need to do it by raising prices, they will if they can.