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The Inflation Knuckleball

Economics / Inflation Mar 29, 2011 - 12:17 PM GMT

By: Michael_Pento

Economics

Best Financial Markets Analysis ArticleBy its very definition, fiat money is something created out of thin air: the word "fiat" is Latin for "let it be done" (as in, by decree). But the convenience that such a currency system offers central bankers is paid at the expense of savers.

With nothing of real or lasting value on which to anchor, the value of fiat currencies can always blow away like ashes on a windy day.


For the past 40 years or so, every country on the planet has relied on fiat money.

To a very large extent, this means that the national economies are far more exposed to the whims of their central bankers than they have been in the past. So, if central bankers go off their meds, the danger to the currency becomes profound. Unfortunately, at America's Federal Reserve, it seems the inmates are now running the asylum.

We are being led to believe that falling prices are evil, and that only an increase in inflation can save our economy. From the moment the financial crisis took hold in 2008, Fed Chairman Ben Bernanke has looked to lower the dollar's value and cause asset prices to rise - especially in real estate. But his pitch is wildly off the mark. The Fed can't control the exact rate of inflation, nor can it direct where inflation will be distributed across the economy. In other words, inflation is like a knuckleball: once you let it loose, you're never really sure where it's going to go. And Bernanke's pitches are so wild it would make Tim Wakefield jealous.

Thus, we are seeing rising prices everywhere except where Bernanke really wants them - real estate. Data released last week shows that the median price of existing homes declined 5.2% in February compared to the previous year, to $156,100. New home prices fared even worse; the median sales price dropped to $202,100 in February, from $221,900 a year earlier - a tumble of some 9%!

However, commodity prices provide the arena in which the the Fed's lack of inflation control becomes most apparent. So far this year, gold is up over 4% and the CRB Index is up 8%.

Meanwhile, over the same period, the dollar has dropped over 4% against other fiat currencies, according to the Dollar Index. This has occurred despite global economic developments that would normally benefit a currency that has "reserve" status: Japan, the world's third largest economy, has been taken off-line due to a catastrophic earthquake; the EU is facing another massive bailout bill as Portugal failed to pass austerity measures; and, a sandstorm of destabilizing revolutions is sweeping through the Middle East. Yet, instead of providing a safe haven for skittish capital, the dollar has recoiled.

It's really no wonder that faith is waning. As the dangers of inflation become increasingly apparent, there is still no prospect for a change in policy any time soon. By all reasonable accounts, commodity prices will continue to surge as real interest rates continue to fall. Right now, the yield on the one year T-bill is .23%, while the YoY increase in inflation is 2.1%. And this is using the government's twisted figures!

I estimate real interest rates are somewhere close to -8.75%. Therefore, investors are being thrust into the arms of precious metals and away from dollar-based assets.

There really isn't much choice.

However, since the real estate market was in a prolonged and lofty bubble, it will be the last asset class to respond to the Fed's dollar debasement strategy. Although Bernanke is noted for his Great Depression scholarship, it should be obvious by now that he never spent much time studying asset bubbles. If he did, he would have learned that gold took decades to recover from its crash in 1981. The NASDAQ is still 45% below its all-time nominal high set over a decade ago. And, unlike housing prices, these markets were allowed to clear themselves after their respective crashes.

Prices dipped more than 70% before turning north in earnest. In contrast, home prices are being kept in a rump bubble by Fed stimulus. Amazingly, since 40% of the core CPI is owner's equivalent rent, Bernanke will continue to miss the mark about the true level of the inflation he has created.

The aftershock of the real estate bubble has sent millions of homes into foreclosure, left 11% of homes vacant, and caused 23% of mortgage holders to be without any equity in the home. Unless the Fed starts to create credit to buy houses directly off the market, it will be very difficult to get real estate values to move higher.

It is clear that by trying to channel his inflation into just one asset class, Bernanke has placed the entire US economy in severe danger. He now faces a serious conundrum.

Does he raise interest rates significantly to fight inflation at the cost of a second housing market collapse, or does he sit idly by and watch the broader economy become as unaffordable as a resetting Option-ARM mortgage? Neither choice is pleasant, but one thing's for sure: if the bond vigilantes start to raise interest rates for him, we'll know his knuckleball missed the strike zone.

For in-depth analysis of this and other investment topics, subscribe to The Global Investor, Peter Schiff's free newsletter. Click here for more information.

By Michael Pento
Euro Pacific Capital
http://www.europac.net/

Michael Pento, Euro Pacific Captial as the Senior Economist and Vice President of Managed Products.


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Comments

gAnton
29 Mar 11, 19:39
Is Bernanke Losing All Control?

Very slowly over the last five years or so BernankeĀ“s actions are having more and more unintended consequences and/or effects contrary to their intended effect. For example, for years now he has been trying to "recover" the housing market, and he has spared no effort, buying up trillions of dollors of worthkess mortages, etc., etc.. The results of his efforts speak for themselves!

The classicial central bank tool for controlling inflation has been to increase interest rates. When the coming inflation finally forces Bernanke to increase interest rates, the effect will be to accelerate rather than deaccelate the inflation.

In short, soon it will make little difference what Bernanke does--his acts will be inconsequenctal and irrelevant to the real economy.


Nadeem_Walayat
30 Mar 11, 03:38
Inflation

Central banksters want inflation so that they can create the illusion of rising house prices in nominal terms.

The Bank of England started losing control in Sept 2007 when Northern Rock went bust and accelerated during Sept 2008.


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