RIYADH, 10 July 2006 — At 7:15 p.m. London time on June 29 came the news we already knew: the Fed raised rates an 17th time — to 5.25 percent.
Inflation will be tamed! Deflation, be damned! That week, the “Bank of Bernanke” stuffed more rounds into the ammunition chamber. Its key lending rate rose from 5 percent to 5.25 percent — the 17th slug since the Fed began “reloading the gun.” Stockpiling this kind of ammunition is supposed to make the dollar a little safer. And a little stronger. And so, it is in the currency markets. While the dollar “should” go down — heavy trade deficits and federal deficits are wrapped around its neck like millstones — it isn’t going down yet.
But the plot needs clarification.
There are two kinds of inflation. There is the kind that everyone hates: When prices for cigarettes and drinks go up. And there is the kind that everyone likes: When prices of their houses and stocks go up. The Fed has become an “inflation hawk,” they say, because it is becoming vigilant about increases in consumer prices. Raising interest rates is supposed to mean it’s girding its loins to fight them. But depending on how you measure it, cost of living is rising no more than it has been for years — each year, consumer dollars lose two to five percent of their purchasing power. And who complains? The risk from consumer price inflation is only more consumer price inflation. But that is not the risk that the Fed really fears.
That is not why Ben Bernanke is loading the gun. No. Americans aren’t upset about consumer price inflation.
It’s the risk from the second type of inflation that is the real danger, because asset price inflation is usually chased by asset price deflation. After prices go up, they must go down. A bear market follows a bull market. Bubbles are popped. And all of a sudden, investors don’t feel so wealthy. They cancel new investments. They cut off new projects. They pull back, and the whole economy pulls back with them. This is what happened in Japan...and it is what Ben Bernanke has had his eye on for many years.
Only, today, asset price inflation threatens much more serious damage in America than it ever did in Japan. Japan’s lower and middle classes were never lured into outrageous levels of debt as they have been in America. In the land of the free, the lumpen mistook the Fed’s bonanza for real wealth. They thought they could “take out” money from their houses, even though they couldn’t remember ever putting it in. They began to believe that this brand of inflation was the same as the other and that they could depend on regular, reliable increases in their house values. Why not just spend the money, they asked themselves.
And they borrowed. And now they have to pay interest on their debts. And now Ben is making it much costlier for them to do so. Mortgage rates are back up to their highest level in four years and consumer confidence is going wobbly.
Headlines report rising default rates.
Ben Bernanke, once in charge of Princeton Economics Department and now in charge of Americans’ economic future, is not only loading the pistol...he is pointing it at their heads.
(Khan H. Zahid is chief economist and vice president at Riyad Bank. He is based in Riyadh.)