Rate Cuts and Inflation: Linkage Overblown?

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 |  Includes: DIA, IEF, SPY, UUP
by: Vikram Saxena

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.