Not Quite

It was only a few short weeks ago that pundits were all over the airwaves warning us about mega-inflation, rapidly-rising interest rates and a mass exodus of foreign investors from the U.S. dollar.



Since then we have had a 10-year treasury note auction with record buying by foreign investors, including central banks.. We also saw take consumer prices, softer-than- retail sales, a leveling off of jobless claims after some improvement, lower capacity utilization and lower interest rates.



Many market participants expected the Fed to begin hinting that it is ready to change course. However, Fed Chairman Ben Bernanke defended his policies during a G20 meeting this morning.



In his speech he implored China to increase the value of the yuan. Mr. Bernanke stated that commodity prices have risen “significantly” due to increased demand from emerging economies. He went on to say that countries which freely float their currencies “have seen their competitiveness erode relative to countries that have intervened more aggressively in foreign exchange markets.”



This is precisely why China closely manages its currency. China’s policy makers know full well that if the yuan appreciates too much, either China’s export prices would have to rise or their profit margins could be squeezed. Neither option is particularly desirable for China’s policy makers. Smaller profit margins could squeeze businesses. Higher prices could mean lost market share as other emerging economies would likely become price competitive.



There is another method to Mr. Bernanke’s madness. The Fed has been much criticized for helping to push commodities prices higher by keeping rates low, thereby weakening the dollar. There is more than one way to lower commodity prices. Yes, the Fed could begin to tighten, but that could put added downward pressure on real estate prices as higher rates make homes less affordable. It could also nip the recovery in the auto sector in the bud. Another possible result of Fed tightening could be higher borrowing costs for corporations. Such a scenario could severelynegatively impact corporate borrowers, especially those on the lower end of the credit quality scale.



Another alternative for would be for China to permit the value of the yuan to rise to what the market will bear, thereby slowing China’s economy and reducing the demand for commodities. China’s demand for U.S. treasuries (U.S. dollars) would probably shrink and U.S. long-term rates could rise and the yield curve steepen. However, higher long-term yields could entice other investors thereby limiting further dollar weakness. Round and round we go. The bottom line is that China’s “management” of its currency is making life difficult for central bankers around the globe. It does not appear as though drastic changes to China’s currency policies are imminent.



To consumers, inflation is an price increase which affects their daily lives. To the Fed, inflation are price increases of goods and services which have inelastic demand curves which can impair economic activity. Currently the Fed is dealing with inflation among commodities, but stagnation in the price of services and wages. In fact, some areas of the service economy are cutting prices to increase business. Housing continues to be a problem. Sure, the Fed can raise rates, strengthen the dollar and help bring down food and energy inflation, but what would that do to housing of the manufacturing-led recovery? The result would probably be the economy grinding to a halt.



We all must realize that the economy many of us had come to view as normal was not sustainable. Home prices cannot be expected to double every few years. Equity markets cannot be expected to rise 20% each and every year. Not everyone can own a McMansion and a $40,000 SUV. The sooner this is acknowledge, the sooner the country can move forward.


Please read Andy Kessler's op / ed in Wednesday's WSJ.