Inflation Con Job
October 2, 2004
For the past 6 months or so I've been wondering about the incredibly low inflation numbers being released by the Fed. With prices of oil, steel, and other commodities rising so high, surely the prices of durable and consumer goods would have to be going up. Even excluding food and energy, (a dubious consideration which I'll leave for another post,) a trickle-down effect from raw materials to the price of completed goods is inevitable.
Some time ago I suspected that the cause of such a low number was some sort of stealth deflation. Turns out that I was wrong. It seems that rather than prices in some sectors falling significantly to offset other prices rising, it seems the government is intentionally skewing the numbers to make it appear that prices are not rising as fast as they really are. According to PIMCO Managing Director Bill Grossman, the government has been taking advantage of something called hedonic adjustment to artificially state a lower rate of inflation than is actually observed.
A distortion like this would have huge ripple effects on the national and global economies. Primarily, higher inflation would significantly dis-incentivize the holding of US Treasury bonds. If inflation is really closer to 3.7%, that would mean that the holder of a 10-year bond would only be getting a return of 0.5% after inflation. Holders of shorter-term treasuries would find themselves actually saving at a negative rate! Naturally, few rational investors would want to hold bonds for such a paltry return, and would be likely to sell. As mentioned before, the largest holders of US Treasuries are foriegn investors; if they sell their bonds, and then repurchase their own currency with the proceeds, they push down the value of the US dollar. This, in turn, causes prices to rise further, and perpetuates an inflationary cycle.
If this article has any truth to it, and I suspect it may based on my own observations and intuition, we could see a big shakeup in the bond market in the coming months.
Posted by Jason Pront at October 2, 2004 7:49 PMWhy do you think the euro and other foreign currencies have been so strong against the dollar? There is little to no incentive for foreign investors to hold dollar denominated securities.
Also in reply to your comment on my blog, I would argue that you don't understand the effect that oil has on the world economy if you think that oil will increase gradually due to an excess demand situation. Go back and look what happened to oil prices in 1979 and 1973 when there were artificially created supply shortages. Also realize the price of oil has doubled this year alone, and the oil supply is still sufficient to meet demand. When people realize their SUV heroin is in short supply, the bidding war will begin in earnest.
Posted by: bubba at October 3, 2004 6:08 PMI agree that there is little incentive for foreign investors to buy dollar denominated securities. Yet they keep on buying. In particular, the Chinese can't seem to get enough of US Long Bonds. I'm worried about what happens when they realize how little incentive there really is to hold these bonds. Then we'll really see the dollar get devalued.
I think we're arguing different points regarding the oil situation. You believe prices will rise because of an increase in demand. I believe prices will rise because of a reduction in supply. Semantics perhaps, but therein lies the reason why I think it will be a more gradual rise.
Both 1973 and 1979 were sudden shifts in supply. I'd argue that a gradual reduction in supply would result in a more gradual change in price. Using this year's spike as an example, we see significant price shifts due to the terror premium, unrest in both Uganda and Venezuela, and repeated supply disruptions in Iraq. None of these, I'd argue, are gradual shifts.
Posted by: Jason at October 4, 2004 12:19 AMEr, that should be Nigeria, not Uganda. Late night last night.
Posted by: Jason at October 4, 2004 12:23 PM