Stockerati

A friend wrote to me this weekend in response to my posting on Inflation versus Interest rates. I decided to post some snippets from our exchange as they highlight a very interesting & important perspective (Thanks, D!), that didn’t come out loud and clear in my previous post. D wrote:

I agree with you that the Fed will likely raise interest rates.  Inflation is all the buzz these days across the world, and the primary tool we have historically used to deal with inflation is raising rates.  That said, I don’t believe that raising rates alone will do much to help inflation, and in fact could further damage our economy.

I suspect that raising interest rates will only help to curb discretionary spending, not against critical items like food and gas.  In which case, raising rates could even further slow the economy without actually easing inflation.  That is, we have little control over the prices of things which are driving inflation (food and gas), and even if we are able to curb demand within the US, there isn’t anything saying that other countries won’t just rush in to consume the extra supply. 

Since the 50s the US economy has revolved around cheap gas.  It’s allowed us to live far from urban centers and simply commute to the places we need to go.  With our current transportation infrastructure, people simply don’t have alternatives to using gas.  They have to drop their kids at daycare, drive to work, drive to grocery stores, etc.  More importantly, people have to eat.  There is very little you can do to reduce the pressure on the global food market.

I also believe that our current situation (in the US) has had more to do with infinite credit, than with interest rates.  That is, people here have had an infinite amount of credit available, with no regard for interest rates.  If this is the case, then the current credit crunch (while painful in the short term) will be good medicine for the economy, but will take time to run its course.

From my perspective the high world demand for resources is impacted by three major factors:

1. Sheer scale of population.  Countries with enormous populations will continue to have high demand, regardless of interest rates.

2. Vast cash resources.  Countries with new oil wealth have a massive cash surplus, which impacts not only consumption, but also investment options.  I believe the sub-prime crisis was less a factor of interest rates, and more a factor of having too much money available, with not enough investment options.  As a result, investment houses funded bad loans so that they had more "product" (batches of mortgages) to sell.

3. Infinite credit.  Reiterating my earlier point, interest rates are irrelevant if people (and governments) have ready access to funds.  We’re addicted to cash, and constantly looking for our next fix, regardless of the long term consequences.

So while I agree with you that much of the cause of inflation these days is that there is too much money out there, I see raising interest rates as only a partial solution to #3.  Without solutions for #1, and #2, as well as better regulation of credit practices, raising interest rates could do more harm than good.

My response, in its entirety was as follows:

Let me first list out things that you and I are in agreement on:

1) Raising interest rates will not impact oil and commodity prices directly

2) American public has been spoilt and pampered for the past decades by cheap gas. It’s a birth-right to most and not a privilege

3) Infinite credit’s a substantial component of the current problem(s)

To answer your questions, I believe increasing the interest rates and changes in fiscal policy are in the order. Increase in the rates coupled with regulations binding banks to maintain X% of their resources as cash reserves serves two primary purposes:

1) It tightens the money supply. Less money floating around means a competitive loan environment. Only the most suitable and less risky applicants get the loans @ a higher interest rates.

a. The major cause for the subprime problem was too much money  for too long which created detrimental competition between lenders . At low interest rates, once the risk-free loans were given out, and the interest rates still continued to be low, all that the lenders could do was to compete between themselves for the next strata of the populace, which increased the risks significantly. Lenders just had to find people willing to take loans (and huge loans too) versus finding people who could actually afford loans

2) Tightening of the money supply and increasing the interest rates also impacts the credit card industry. CC are issued by banks. If the Feds require banks to hold a certain part of their reserves as cash, then the amount of credit the banks can issue decreases. This means that only safe patrons get high credit limits, low interest rate offers whereas the Joe Schmo’s get low or no credit @ higher rates.

The above addresses #2 and #3 factors you mention below. However, to tackle #1, the dollar has to be strengthened. US is the only country in the world which writes its debt in its own currency. The hegemony of the dollar has continued for long and there’s no reason why it shouldn’t carry on in the future.  But in order to do that, we have to attract investments back into the US. We have to build up our exports so that more $’s come back from other countries. Getting $’s back into the US creates new opportunities and better return on investments for all those (includes you and me) investing domestically. Our current problem is that US is no longer an attractive investment destination and therefore, the money has been trickling into economies such as India and China. The middle classes there are burgeoning, thereby, creating an intense pressure on commodities and resources. If the $ is strong, it’ll cost Americans less to buy stuff compared to their Indian or Chinese counterparts. This means, folks in those economies who are just getting accustomed to cheap and affordable commodities will have to make the necessary trade-offs. We, as Americans, still need to be more rational than ever before on our resource usage—but we are spoilt and have the historical inertia working against us. For example, today the dollar to Indian Rupee exchange rate is 1:40. Say, a gallon of gas costs both Americans and Indians $4 (or Rs. 160). If the dollar was to strengthen and reach its prior levels (1:50) then the same gallon would cost Indians Re 200. This hike in the price of gas, will force Indians to cut down their gas dependency and usage and search for other cheaper and affordable forms of energy such as CNG, LPG or even coal– global warming, unfortunately, will become the elephant in the room again. This same argument holds true for China. Net-net. a stronger dollar keeps prices down for Americans by increasing the prices for the rest of the world—only way to ease pressure on the limited resources available today.

There’s no silver bullet here. But in my opinion, 3 things have to happen simultaneously to make progress and address the points you hit on in your mail:

1) Interest rates have to be raised

2) Cash Flow in the banking system and thus the economy has to be reduced, controlled and regulated

3) Dollar has to be strengthened

A strong dollar also bolsters the buying power of the American economy. It creates abundance and affordability for Americans, while incenting economies (read Countries) to boost their exports of commodities and food to the US, as everybody then wants to bring dollars home. An import-based economy can only be successful if its buying power is its biggest leverage—we’ve lost that edge some offlate and it’s time we gained it back.

What do you think?