Is This The Real Life?

The debate over inflation rages on. Some believe that inflation will continue to spiral out of control. Others believe that higher food and energy prices will keep overall inflation low by reducing consumer demand and it will all work out with little overall pain for U.S. consumers. Although I agree that higher food and energy prices will help hold down prices in other areas of the economy. Consumers will be squeezed if food and energy prices decouple from the rest of the economy.

In the past, price moves in nearly every sector of the economy were the result of increased or decreased domestic demand. The oil supply shocks of 1973 and 1979 are notable exceptions. During these periods, energy prices began to rise an inordinate amount versus prices in other sectors. However, at that time, companies had sufficient pricing power to raise prices to compensate and labor had enough leverage to win wage increase. This led to high broad inflation and high interest rates which led to stagflation.


Now, companies do not have the pricing power to easily increase prices and labor has little leverage to win wage increases. So is all well? Not hardly. During the past 25 years, the U.S. economy has thrived on leverage (borrowed funds) to thrive. Prices have outstripped wages by large margins, but cheap financing has enabled consumers to borrow to embark on a spending binge. Cheap financing has also caused real estate values to rise sharply enabling homeowners to use their homes as piggy banks. These days are now at an end.

The result is that not only are consumers not making discretionary purchases, many are having difficulty feeding their families in the manner in which they are accustomed. I see serious trouble ahead for U.S. consumers as they have little influence on energy prices and are unlikely to experience rising incomes.

Unless energy prices can be brought down, the U.S. economy will be stuck in a kind of twilight zone, not quite in recession and not quite in expansion. The easiest and most expediant course of action is to tap our domestic energy resources, but environmentalist are blocking this course of action. I am an environmentalist, but I am also a pragmatist and U.S. citizens come first.

What about oil speculators? Since oil prices have risen more than demand during the past year, there is likely to be a correction at some point. However, if oil falls beyond the mid $90 area ant any time in the future (unless more supply can be brought on line) I would be shocked.

What about interest rates? Look for long term interest rates to continue their recent rise. I would not be surprised to see the 10-year treasury note at 4.50% and the 30-year government bond at 5.00% by July 4, 2008.

What about short-term rates? They promise to stay historically low, but a bit higher than present levels. The Fed controls the short end of the yield curve and is not in a position to raise rates dramatically. Look for small increases by either late 2008 or early 2009.

What about a repeat of Paul Volcker's rapid rate increases to quash inflation? The Fed will have a difficult time doing this. Raising rates will not cause Americans to consume less food and energy, unless they become so destitute that they can't afford to subsist.

What about higher rates strengthening the dollar? That is likely to happen if and when interest rates on the intermediate portion of the yield cure reflect true inflation pressures. As this will probably happen, look for the dollar to strengthen modestly and for energy prices to stabilize or fall slightly, eventually. To help food prices, using ethanol as a fuel or fuel additive needs to be reconsidered.