The Fed is NOT in a "tight spot"

Here is a graph of the Consumer Price Index, from economic and business database specialists Haver Analytics. The graph shows better than words the stark reality that the Fed's excessive easing has introduced unacceptable inflationary pressures into the economy.

According to the July data released by the U.S. Bureau of Labor Statistics yesterday, the CPI is now up 5.6% over the past year. At that rate of inflation, your money will lose half of its purchasing power every thirteen years. If you have a million dollars today, it would have the purchasing power of just $500,000 by the year 2021. If you have a five-year old child now, your dollars when he enters college at eighteen will purchase half of what they will purchase today (at least in terms of room and board: college tuitions have been rising at more than the CPI for several years now).

Many media observers are spinning yesterday's inflation readings as putting the Fed in a "tight spot," because they know that the Fed is supposed to provide price stability, but believe that the Fed cannot afford to raise rates because it would "hurt the economy."

For example, the New York Times yesterday ran a story saying, "The Federal Reserve can try to choke off inflation by raising its benchmark interest rate. But such a move would also make it harder for businesses, banks and households to obtain loans, which could cause a further slowdown in the economy. Investors now expect the Fed to hold rates steady until at least the end of the year."

We strongly disagree. We have argued in previous posts, such as this one and this one, that if the Fed would concentrate on providing a stable currency it would help the economy, not hurt it.

Contrary to the argument from the New York Times quoted above, raising rates and choking off inflation would actually help businesses, banks, and households. As economist Larry Kudlow explained in an insightful blog post a week ago, inflation ripples through the entire economic system, and inflation relief does the same.

Inflation relief can help households on the margin of being able to make their home payments to avoid falling over the edge, which would mean fewer foreclosures, and lower the level of problems inside the collateralized debt instruments held on the balance sheets of various financial institutions.

Businesses would be helped far more by the Fed providing a stable currency than by providing lower rates. Inflation is extremely damaging to businesses that have to purchase more expensive materials or components, and can cause compressed margins as they are forced to either raise prices or eat the difference.

Finally, banks would also benefit from the Fed getting the Fed funds rate back up where it belongs, as we explained in this July post entitled "The dark side of 'making hay while the sun shines.'"

In short, we believe that the people who are calling for more Fed cuts are failing to see the threat posed by inflation, and that those who are saying that the Fed should cut but now will have to hold steady are also misguided. Inflation does not moderate all by itself. We believe that the Fed should raise rates immediately, and agree with Dallas Fed President Richard Fisher who dissented from the majority in the last two Fed meetings, voting for a rate hike in each of them. He also voted in April that the Fed should not have lowered again, although he was outvoted in that meeting as well.

In the meantime, we would argue that the Fed is not in a tight spot at all: they should stop trying to steer the economy, which only creates problems, and stick to providing stability in prices. An inflation reading of 5.6% makes it extremely clear they have work to do.


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