Rate Cuts and Inflation: Linkage Overblown?

The air-waves are full of talk about recession, inflation and stagflation. Longer term interest rates are increasing while the Fed continues to cut the Fed Funds Rate, to bring short term rates down. A number of observers are questioning whether the Fed's decision to focus on growth rather than inflation is the right one. Conventional thinking suggests that lower Fed Funds Rate will increase inflation since it spurs economic activity and growth. However, there is not much written on the mechanics of inflation, and the amount of control the Fed has to manage inflation.

In the current context, I would like to view inflation along the following three dimensions:

• Commodity Costs: The cost of the basic natural resources
• Labor Costs: The cost of wages paid to workers
• Infrastructure Costs: The cost of using existing (or building new) factories, hospitals, or computer networks

Commodities

If the soaring price of commodities is any indication, the prime driver of inflation in the USA today is the cost of raw materials. The cost of raw materials as defined by the price of energy, metals, and agricultural commodities, is increasing at a rapid pace. The billions of people in the developing world integrating into the world economy are putting an immense demand side pressure on these resources. This a fundamental change in the global economic structure, driven by the desire of billions to have a better quality of life.

It can be self-satisfying for developed countries to believe that the growth in the emerging markets is being driven by the demand from them. However, the correlation is much weaker than it used to be. China and India have a very well defined and rapidly growing internal market. Brazil and Russia are major exporters of raw materials and are riding the commodity wave up. The size of their middle-class in these and other emerging markets is growing rapidly. Though any slow-down in the developed world will impact the emerging markets, it will not significantly reduce their growth rate.

Studies suggest that the Chinese economy will grow by 2% less if the growth in the developed world goes to zero. So any effort to reduce growth in the developed will not have a significant enough impact in the growth, and the hence the demand for commodities in the emerging markets.

Infrastructure

The US production infrastructure is not being utilized at a point where it can drive inflation. Recent indications suggest a slowdown in business spending which suggests that businesses do not see production constraints as a factor.

Wages

Similarly wages in the US are rising moderately or stagnant at best. There is little evidence that the wage growth is driving inflation in the US. In fact, consumers spending, which is closely tied to wage growth, has been stagnant and seen as a sign of an economic slowdown.

It is obvious to me that the Fed should not view inflation driven by the increase in the price of commodities as a reason to not lower interest rates. The price of commodities is going up due to demand which does not have a strong connection with the Fed Funds rate.

Fed and the US Dollar

One thing to watch out for sure is the value of the US Dollar. Lower interest rates in the US are being blamed for the weakness in the US Dollar. This in turn drives up the price of imported goods, including dollar denominated commodities. I believe that there are other factors, primarily geo-political which are affecting the US Dollar; perhaps much more than the low US interest rates.

The Euro Zone has emerged as a viable economic entity over the past decade and now offers a viable stable alternative to the US Dollar. Further, since the Euro is managed by a large number of countries, often with different foreign policy objectives, it is viewed as relatively free from political interference. In the post 9-11 world, US foreign policy has not won too many friends. Some of the saber-rattling has led to fears that the US might freeze assets of countries considered unfriendly, leading to a flight from the US Dollar. It is likely that the post Bush White House with a more nuanced Foreign Policy will be able to alleviate some of the fears.

How to handle commodity price inflation?

On the flip side, the high price of commodities has finally created an economic case for investing in technologies which increase the efficiency of resource utilization. Our economic policy should strongly focus on investments in increasing energy efficiency, and reducing resource wastage. Investment in efficiency will not only help us reduce our impact on commodities but also allow us to export the technology we develop, to the rest of the world.

Further we need to reconsider policies which result in inefficient utilization of domestic resources. We limit the import of much cheaper sugar-caned based ethanol produced in Brazil due to the pressures of the corn and sugar lobby which gets billions in Federal subsidies. This has increased the price of corn; further it has reduced the land devoted to other crops increasing their price too. This has a rippling effect in the world's food markets, and directly leads to inflation at the dinner table.

We also need to review our policies with regard to drilling and exploration within the United States. Not drilling for oil off the coast of Florida will not change the ways in which OPEC gets their oil; however it turns back the clock on any investments to make the process more environmentally friendly. The environmentalists are hitting themselves in their foot by limiting the incentive for investments in greener resource-harvesting technologies. Investment in this area can result in technologies which reduce the environmental impact of these efforts.

Uncle Ben: Continue on the path you have taken…

The US can take many actions to reduce the impact of the growth in the price of energy and commodities. The Fed not lowering interest rates to control inflation is not one of them. Lower short term interest rates will allow banks to enjoy a wider spread in the loans them make, which will compensate them for the additional perceived risk. This will help unfreeze the credit market and also spur domestic consumption and business investment. Credit is the life-blood of the American economy and getting the credit-markets to work smoothly should be the prime objective of the Fed; not fighting inflation due to higher commodity prices.

Comments

[nitroae23]

Volcker will be suprised to hear his raising of fed funds through the roof in the 80's might not have had anything to due with inflation becoming a non factor for the next generation,how old are you?

[Vikram]

nitroae23:

We live in a different world than which Volcker lived in. The USA no longer is the largest driver of raw-material consumption that it was two decades ago. The growth in demand is coming from countries whose economies can grow significantly organically, with out much help from growth in the developed world.

Increasing interest rates in the USA will not have a significant effect on the consumption of raw-materials in the emerging markets. Hence interest rates are not the right tool when it comes to commodity driven inflation in the USA.

Incidentally, what fixed the energy driven inflation during Volcker's time was the increasing energy effeciency and greater oil supply coming on line. We need to focus our interest on that; not on the false hope that decreasing growth in the West will sufficiently decrease demand in the emerging markets.

en.wikipedia.org/wiki/...

[nitroae23]

Vikram,brother,is this the "New Economy" that I heard so much about in 2000?Is it finally here,phew,that was quite a wait!!! So called emerging markets are intimately linked to ours,as we go down,they'll go down MORE,decreasing confidence in the coin of the realm by devaluing it will only escalate things and increase inflation as most if not all commodities are priced in dollares sic!

[Vikram]

nitroae23:

A lot of people in the West confuse the correlation between the markets and the economies of the developing economies. The markets, especially the equity markets, will continue to be strongly correlated. However, the underlying economies are not.

Growth in China and India is not only been driven by the West but also their internal growth. These economies were long shackled by artificial constraints, which are gradually withering away and they are going to play catch-up with the rest of the world.

To learn more, watch the interview on CNBC with Mohammed El-Erian (PIMCO/Harvard) one of the most respected investors on Wall Street. El-Erian understand emerging markets better than most.

www.cnbc.com/id/158402...#

Around 4:00 Minutes is where the discussion about emerging markets start.

[robster]

I disagree with the author. While i understand that lower rates could encourage investment in technology to increase productivity this is not a given. Your input costs driven by commodities is a given and are increasing. Why aid and abet these costs by lowering rates to punch bowl levels again? Inflation is the number 1 enemy of any economy!

[Vikram]

robbyt:

The issue is not whether inflation is good or bad. There is no doubt about that.

The issue of debate is the degree of control which the Fed has in reducing inflation in the current environment. Since the inflation is not being driven by US consumption, the senstivity of inflation to the Fed funds rate is much lower than it used to be in the Volcker era.

On the other hand, what is quite certain is that lower rates will provide support to the US economy. Once the credit markets and the housing markets stabilize, the Fed can attack inflation at will.

Even in Volcker's time, what got us out of the inflationary spiral was increasing effeciency and greater energy supply. His rate increases helped limit US growth till the energy demand/supply situation became balanced again. However right now, any rate increases in the US will not significantly affect the demand in the emerging economies. They might strengthen the dollar but there are many other factors at play when it comes to the dollar. Remember that the Fed Funds Rate were much lower and the Dollar much higher in the Greenspan era.

[SIMPLE d]

C'MON. Inflation is being caused because there are too many US dollars printed.

Period. Commodities are going up because 1) the USD has weaker purchasing power, and 2) investors purchase commoditities as a hedge, ride the upsurge, etc.

What can the Fed do? Resign. Would be the best option, in the long haul. Other than that, they could contract the money supply, which would mean smaller budgets across the board. FACT. We need to consider that GROWTH has reached its limits under a fiat money system.

[Vikram]

SIMPLE d:

It is again a US centric view. What we got to realize that the US and US consumption is no longer the prime driver when it comes to the demand for commodities. That is a fundamental shift from the past.

It is easy to blame excess money supply for inflation. However, in the US economic structure most of the costs are in distribution and marketing; not in production. The raw material cost is a very small percentage (except for energy which is a tax across all elements).

I agree that the US Dollar is a major factor. However, there are other factors in play apart from interest rates when it comes to the dollar. Look at the interest rates in the Greenspan and the value of the dollar to get an alternative perspective.

[robster]

You have just contradicted yourself, saying the inflation is driven by emerging markets but then you say in actual fact input costs as a result of raw materials only makes a small percentage of product costs. So does this not mean that increasing rates will indeed make a difference as the major costs are marketing, distribution and hence wages. You are confusing the subject.

[Vikram]

robbyt:

There is nothing contradictory about what I have written.

In emerging markets the cost of the raw material is a major component of the production cost since labor is cheap and marketing is a much smaller component. In the US, it is the cost of labor and marketing which dominates the cost of raw materials when you consider the cost structure.

To get a perspective, the price of most commodities has gone up multiple times but inflation in the US still in the low single digits. That highlights the impact which commodity price increase has in the US; visible but not in the same order of magnitude.

However just because commodity prices translate to inflation to a lower degree does not mean that they are the prime cause of inflation right now. And higher Fed Funds Rate will not have any direct impact on the price of commodities (except for their effect on the exchange rate).

[Vikram]

That should read:
However just because commodity prices translate to inflation to a lower degree does not mean that they are *NOT* the prime cause of inflation right now.

[robster]

the commodity boom is also largely based on speculation so the speed with which commodities have gone up in the last 6 months is incredible. It won't feed into CPI as quickly (much like interest rates don't feed into economic activity straight away) but CPI is still on an upward trend. And thats the last i'm saying on it.