Inflation and the Fed

I don't know who said this, but I'll paraphrase: "An electorate gets the leadership it deserves." Well, the recent demonstration of legislative and Presidential brinkmanship about the debt ceiling certainly doesn't reflect well on we the people who elected them. The good news is that it could be worse. We could be the European electorate, who get whipsawed by their own national leaders and by both unelected bureaucrats in Brussels and a European Central Bank.

Let's go back to the early days of the financial crisis when it was being described as a crisis of liquidity. Well, the U.S. Federal Reserve unleashed a historically unprecedented global tsunami of liquidity. It had to be reflected in the markets for financial assets, and yet this basic economic insight has been pooh-poohed repeatedly.

Joseph Carson, U.S. Director of Global Research for Alliance Bernstein, writing in his August 5th letter notes, "Looking back, the Federal Reserve's second quantitative easing program (QE2) is partly to blame for the surge in commodity prices that has weighed on growth this year. Although several factors contributed to the sharp rise in oil prices, ....a sharp increase in commodity prices began to develop almost immediately after the Fed started QE2 last November."

There's really no fundamental inflationary pressure worldwide because of deficient aggregate demand compared to worldwide excess capacity in key industries, such as steel, natural gas, and aluminum to name a few. Much of this excess capacity has been built in China.

As a mirror to U.S. fiscal profligacy, there is the totally inefficient allocation of capital in the Chinese model of state capitalism. In a drive to build capacity for its own projected GDP growth rates of 10% per annum and to become a global exporter of industrial goods and machinery, China has invested heavily in basic materials like steel and aluminum. All of this activity has fed back into their commercial real estate bubble. Skyscrapers bigger than the Empire State Building were to have been built already, but like our "shovel ready" infrastructure projects, these projects are vacant lots. The stimulus loans for the projects have already been disbursed, and these loans, wherever they reside, are bad and unrecognized on public and private financial statements.

So, again, from the point of view of the real economy, it's almost impossible to pick up a real sniff of rising inflation trends, apart from what's being driven by the continuing misguided monetary policy. Monetary policy will also do nothing for global employment.

Mary Ellen Stanek, CFA the Chief Investment Officer for Robert W. Baird's Fixed Income funds wrote recently for her clients, "We are not seeing signs of worrisome inflation...while there are visible signs of inflation in food and energy, these pockets of inflation have not....worked their way into longer term inflation expectations in a meaningful way." If the bond market imposes inflationary discipline on issuers, then this opinion from a big, savvy player carries a lot of weight.

The stock market may be waking up to the fact that lots of liquid assets on the books of public corporation are nice to have, but in the long run deficient global aggregate demand and a zombie consumer sector with over leveraged households mean low unit growth and lack of pricing flexibility. Not great for earnings.