Will Inflation Keep Bubbling?

The Federal Reserve's two-day FOMC confab begins today and the futures market's expecting a 25-basis-point cut in Fed funds to 2.0% when the meeting concludes tomorrow. After witnessing a string of cuts since last September, at a time when inflationary winds have been blowing harder, the chatter now is about whether this is the last reduction for this cycle.

Leaning toward the view that this will be the end of the cutting is Peter Berezin, Goldman Sachs' global economist. Berezin told Agence France-Presse:

We expect this to be the last cut, but the Fed will be flexible in responding to economic conditions. Obviously if the turmoil resurfaces, they will be apt to cut rates again. But barring that, they would like to stabilize rates.

Meanwhile, senior financial analyst at Bankrate.com Greg McBride told the Associated Press:

We are entering the stage where it is time for the Fed to wind down and move to the sidelines. A quarter-point reduction is a nice segue to that transition. Short-term interest rates could stay low longer than many currently expect.

Judging by long-dated futures contracts, Mr. Market's calling for another 25-basis-point cut on Wednesday. The Dec '08 contract, for instance, currently prices Fed funds at roughly 2.0%. If the Fed cuts by a quarter point, 2.0% Fed funds at the end of the year would represent the longest stretch of interest rate stability for this series since Bernanke and company kept rates at 5.25% for the 15 months through September 2007.

But let's not get ahead of ourselves. First, let's see what the monetary czars will do (and say) this week. While we're waiting, let's observe once more that cutting interest rates at this juncture may be politically intelligent; it may even look shrewd as the ongoing economic slowdown/recession gathers momentum. But it's also risky with inflationary winds blowing. We'll know if cutting is savvy or something else in a year or so. Meanwhile, it's every investor for him/herself, forcing everyone into their own speculative craft to weather the macroeconomic seas as they come. With that in mind, let's take a dip and consider one blogger's view of the universe.

As we've written many times in the recent past (such as this post from 2005), the warning signs on inflation have been lively for some time. And yet those signs have gone largely unheeded by the central bank. There are any number of explanations, ranging from the view that inflation doesn't threaten all the way to charges of conspiracy and/or incompetence at the Fed. For strategic-minded investors, the true answer matters a whole lot less than whether inflationary momentum has been let out of the monetary bag, and on that score only time will tell.

That leaves us with the distasteful task of forecasting, which invariably is subject to error. For those of us without supreme confidence in predicting the future, hedging one's bets in degrees looks prudent. Yes, we may be wrong, which is why we never bet the house on any one outlook. Still, it's hard to read the various warning signs and remain neutral on the potential for ongoing inflationary risks. Inflation, after all, will affect every investor. The question, then, is deciding how much you can, or can't stand in a world of higher inflation?

Only very wealthy or highly confident investors should opt to do nothing. For everyone else, some degree of inflation hedging looks eminently reasonable. The good news is that a range of choices await, starting with inflation-indexed bonds and commodity funds. The bad news: hedging inflation's potential at this point isn't cheap. In fact, it's downright expensive.

In the same way that buying water in a drought will cost you, so too will the price of buying protection from pricing pressure in late-April 2008. The time for overt inflation hedging is now past. That ship has sailed. We say that because as compelling as the inflation forecast may be, it's not preordained and so buying insurance at this point may entail more risk than is weathering the underlying hazard. Losing 20% in an oil ETF doesn't look all that smart in a world of even 6% inflation.

But all is not lost. There are still indirect means of hedging higher inflation risk, and they're relatively inexpensive too. One example is bonds. Nominal 10-year Treasuries will take it on the chin if inflation rises over, say, the next 12 months, or so we're predicting. One reason is that Treasuries have rallied over the past year, pushing the 10-year's yield down to a current 3.87%, as of Friday's close, from roughly 5.30% as of last June. During that time the annual pace of consumer prices has risen to 4.0% as of last month, up sharply from CPI's 2.6% annual pace in June 2007.

It's no mean feat to see a bull market in 10-year Treasuries as inflation gains a robust head of steam. All of which reminds that in the short run anything's possible in the financial markets, including any number of apparently illogical-looking trends. Still, expecting Treasuries to post another big rally over the next 12 months if CPI keeps rising from current levels may be asking for too much, even in a world of absurd financial news. Accordingly, those who think inflation will still be a problem through 2009 may be inclined to hold a bit more cash than usual with an eye on buying Treasuries at materially lower prices (and therefore higher yields) somewhere in the spring of 2009.

Of course, that brings us back to the question before the house: Will inflation keep bubbling? Ah, if we only knew for sure...

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The period from 1980 to 2002 was one in which USA dollar interest rates fell. Foreign investors bought USA dollars, stocks, bonds, and real estate because they were rising in value due to the decline in USA interest rates. By 2002, USA interest rates were so close to zero that they could not fall further. Foreigners sold us the goods to get US dollars to invest in US assets.

Now the game is played backwards. USA interest rates started to rise in 2003 and they are still rising at the long end of the interest rate curve. The Fed has tried to stop the USA interest rate rise but has failed. Except for short loans, interest rates are still going up. Mortgages, which borrowers can no longer qualify for, are at 7%. 2 year and 5 year interest rates are moving up even as the Fed cuts short rates. Bond prices are falling as are stock prices which means interest rates on them are going up. Stock price to earnings ratios are falling and real estate prices are falling. These are indications that interest rates on long contracts are going up.

Foreigners are jumping out of USA assets and selling USA dollars for other currencies where investment asset values expressed in US dollars are not falling as fast as they are in the USA.