Inflation Accelerating and Interest Rates Rising

The inflation rate continues to accelerate:

CPI - U
3.3% in 2004
3.4% in 2005
4.3% from 6/05-6/06
4.7% for 2006 (last 6 months annualized)
5.1% for Q2 '06 (last 3 months annualized)

CPI - U - Core Rate (ignoring food and energy)
2.2% in 2004
2.2% in 2005
2.6% from 6/05-6/06
3.2% for 2006 (last 6 months annualized)
3.6% for Q2 '06 (last 3 months annualized)

The numbers seem to surprise economists almost every month, but the data is not surprising if one really understands the forces in play.

The Fed continues to raise interest rates in the name of inflation fighting based on an outdated principal. It is assumed that with a higher cost of borrowing, lenders will tighten up their lending standards and loan out less money because of lower profit margins and greater risk. If less money is created by bank lending then the money supply will contract and inflationary pressures will decrease.

This worked in the past, but the Fed has already raised short term rates from 1.00% to 5.25% and credit still appears to be expanding as fast as ever. M2 was up 4.8% from June 2005 to June 2006, and old components of M3 are growing much faster. Institutional Money Funds were up 12.1% Year-over-Year and Large Time Deposits were up 21.1% YoY in June. Surplus money continues to pile up in the accounts of corporations, foreign investors and wealthy individuals at a remarkable rate. This creates the potential for much greater inflation as dollar holders seek to spend, invest or trade them for goods or other currencies. Inflationary pressures have been building up in spite of the Fed's tightening.

If lenders and borrowers behaved rationally in the pursuit of sound long term financial goals then raising interest rates would accomplish the purpose of restricting credit. However, many borrowers are not behaving rationally and many lenders are pursuing short sighted goals at the expense of their long term health. Many consumers have created excessive debt burdens for themselves by over-consuming and/or borrowing too much when rates were low. As rates have risen their rising debt burdens have created great stress and disrupted their standards of living.

Most lenders are large publicly traded companies. Publicly traded companies are typically controlled by executives who are compensated based on short term objectives. Consequently, many large lenders seek to boost short term profits (often with questionable accounting methods) while creating hidden long term risks for shareholders. Lenders have been making high-risk loans and accounting for them with generous assumptions about default risk in order to book large profits. This is occurring to a large extent in the consumer credit and mortgage markets where an over-stimulated economy is temporarily suppressing delinquencies and defaults. When the economy starts slowing substantially, far greater losses will likely be realized and many lenders could be wiped out.

To a large degree, the risks associated with loans to consumers have been passed on to investors and institutions through securitizations. The consumer and homeowner loans created today can be quickly packaged and sold for a profit at prevailing market rates. When this is done it doesn't really matter what the Fed sets interest rates at, as long as there is enough demand for loans by borrowers and enough demand for securities by investors.

Another large source of credit expansion has come from lending to hedge funds. This doesn't get much attention, but I think it is even more significant than lending to consumers. When banks lend to hedge funds they profit from interest payments they collect, from the trading volumes they induce and other services they provide to hedge funds. The profits are large, but the systemic risks they create are huge. To illustrate:

At the beginning of 1998, Long Term Capital Management had $5 billion in assets and another $125 in borrowings. This leverage was multiplied further trough the derivatives markets to the point where they held $1.25 trillion notional value in swaps alone. By September 22nd of 1998, the value of LTCM's assets had fallen to about $600 million without much of a reduction in the size of the companies positions. LTCM couldn't liquidate their oversized positions without wiping out all of their asset value and bankers couldn't make margin calls without causing a collapse of the fund. Eventually the Fed stepped in and organized a $3.5 billion rescue package and many banks recognized hundreds of millions in losses.

The hedge fund world has grown considerably since 1998, and the revenue and profits provided to Wall Street banks has grown proportionally. Compensation at these banks is considerable and mostly based on short term performance. Little regard is given to the long term risks born by the banks and the economy as a whole as trillions of dollars are loaned out to hedge funds.

Hiking interest rates does little to discourage lending to consumers or hedge funds because many of these lenders no longer care about the long term risks. If the Fed wants to tighten up lending standards it will need to do it through the active enforcement of reserve requirements. Traditionally, reserve requirements limited a bank's ability to create new money. Of course banks don't like reserve requirements because they cut into profit margins and limit the profit and revenue growth of the entire financial sector. The Fed is a private sector institution, composed of bankers and serving bankers. The lessons of banking stability from the great depression have been forgotten, and the Fed has gone down the slippery slope of relaxing official reserve requirements. Indeed, the use of securitizations now renders reserve requirements almost meaningless when it comes to limits on creating new credit.

The real effects of rising interest rates are to temporarily support the dollar and to squeeze middle-class borrowers. Both of these effects serve the interests of the bankers that control the Fed. If the dollar falls too fast, then they lose out on currency based derivatives bets. If consumers enjoy a higher standard of living then wealthy bankers enjoy a smaller piece of the economic pie. For those reasons we can expect the Fed to continue tightening as long as they can get away with it.


And a final note:
Many observers believe that the Government intentionally understates CPI for political reasons. Besides making the economic policies of the administration look more effective, understating CPI would also save the government large sums of money in the form of reduced Social Security payments. Without going into too much detail, I believe that methodology changes are pretty consistent in lowering CPI estimates. A quick example that is easy to track is the way weightings were readjusted at the beginning of 2006. Certain items, like gasoline, were given less significance in the CPI, while others, like computers, were given more weight.

If these changes had not been made, CPI - U would have been 4.5% over the past 12 months instead of the official 4.3%. Since both measures include the same weightings for July-December of 2005, the real difference is in the last 6 months, and we might estimate that annualized CPI - U for the last 6 months would have been 5.1% instead of the official 4.7%.

There is always a rationale for methodology changes, but in this case the change seems to counter reason. While consumers may be purchasing a little bit less gas these days, gasoline has gone up significantly as a percentage of most people's budgets. The BLS, however, decided to lower the weighting of gasoline from 4.418% to 4.148%. With gasoline prices up 34.1% according to the CPI data, lowering the weighting of gas has had the effect of understating CPI growth over the last 6 months.