I can't get my head around inflation/interest rates

garyp · Heavy Crude Joined: Apr 18, 2006 Posts: 157

I'm trying to get something straight in my head. Sorry if its been covered before, but I couldn't find it. Thinking goes like this:

- signs suggest a production plateau until ~2010, followed by a decline; 8%+ if you want to look on the black side.

- the housing market looks to have also peaked, Historically it takes 3-4 years at least for such things to reach the bottom

Therefore we are looking at a 4 year timescale when both fuel costs will rise to induce a degree of demand destruction, AND that the housing values will drop at the same time. This suggests both that homes with large commutes will drop significantly, and that homeowners generally will find it difficult/impossible to move.

Now in general higher fuel costs will be inflationary (with a delay of ~ 2years), with a number of companies going to the wall and consumer spending dropping through the floor.

So what happens to interest rates?

In general central banks look to lower such rates to encourage investment by companies during a downturn. That would also help consumers keep their houses and afford higher transportation costs. However if they do so then savings will be quickly eroded and the debt balance will get worse.

So, what would the central bankers game plan in such an environment, and what is the best route for the average inhabitant of this site?

a) keep out of debt and you money in investments, and see the value of that money fall in real term.

b) take advantage of high inflation and low interest rates by getting big loans and invest this money in high yielding investments (if you can find them eg not housing)

c) assume that interest and inflation will be kept in step, so you wait it out with your investments where they are until you can pick up bargains (buy this subdivision and get this one FREE)

d) some other smart idea that I've missed.

Post 2010 is another matter entirely, I'm talking 2006-2010.
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RonMN

We don't know what the fed will do so any way you turn is a gamble.

Will they raise interest rates to save the value of the dollar, but tank the economy?

Will they lower rates to keep the economy running for a short while, & let the value of the dollar collapse?

Will the gov't confiscate gold & silver after TSHTF? (like they did in the 30's).

Will the gov't confiscate land and/or crops after TSHTF?

It seems all roads lead to economic collapse Sad

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Quis custodiet ipsos custodes.

FoxV

I think the Fed will try various schemes to try and salvage the situation but the problem is it is basically out of their hands.

When banks start verging on collapse because of all the bad IO ARMs they have they will save them selves with high interest rates to cover their losses. The Fed could drop the rate to 0% if it likes, but if a bank is foreclosing on 10% of the mortgages it holds expect everyone else still paying to make up for the losses

and don't expect a fixed rate mortgage to save you because a bank that can't cover its losses because of too many fixed rate mortgages, can close down, sell the mortgages to a creditor who is then free to renegotiate a new interest rate for you. And guess what, the new interest rate will not be Fed +3%.

On the otherside 80% of the USDs out there in the world are in foreign hands. This means that when foreigners lose faith in the USD, the Fed can't do anything to stop the value from collapsing. If a foreigner bank wants to 1 Trillion USDs for 100Billion Euros then the value of the USD is now 0.1 Euros. And there is nothing the Fed can do about that.

So what to expect. Huge interest rates, massively devalued (hyper inflated) assets, and eating lots of potatoes.
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jaws · Light Sweet Crude Joined: Apr 24, 2005 Posts: 1257

Higher fuel costs aren't inflationary. Inflation causes higher fuel costs.

Don't listen to Keynesians. They're confusing you.

rwwff

Dreamtwister · Fission Joined: Feb 06, 2006 Posts: 2296

rwwff

Lighthouse · Light Sweet Crude Joined: Mar 02, 2006 Posts: 1458

Colorado-Valley · Intermediate Crude Joined: Aug 16, 2004 Posts: 733

Yep, stagflation.

Bernacke will probably leave interest rates where they are.

If oil depletion gets serious ... run for the hills.

mattduke · Light Sweet Crude Joined: Oct 28, 2005 Posts: 1546

According to the Federal Reserve Bank of San Francicsco Economic Letter which I enjoy receiving:

"In contrast to the US, several countries with explicit long-run inflation objectives seem to have achieved a better anchoring of long-term inflation expectations... These findings are exciting. They suggest that, despite the generally superb performance of the US economy and US monetary policy over the past 15 years, there is still potential for improvement."

EnergyHog · Heavy Crude Joined: Mar 27, 2006 Posts: 215

Have a look at this article, I think it is quite a convincing argument for inflation..

http://www.zealllc.com/2003/infdef2.htm

FoxV

garyp · Heavy Crude Joined: Apr 18, 2006 Posts: 157

Lighthouse · Light Sweet Crude Joined: Mar 02, 2006 Posts: 1458

MrBill · Expert Joined: Sep 15, 2005 Posts: 5650 Location: Eurasia

This is the abridged, long-short version. The US runs a massive current account deficit that consumes 70% of the world's savings. The US will need $1 trillion this year, next year and the next. A weaker USD is not likely to close the trade deficit because the USA no longer makes many of the goods that it imports. A weaker dollar may make US exports more competitive against euro based exporters, etc. but not enough to close the trade deficit. The other side of the current account deficit is the budget deficit, and that is also in the red, and unlikely to close unless taxes are raised across the board and entitlements cut.

The foreigners buying US assets are not necessarily buying USD because of interest rate differentials. They help, but they are not the motivator. Asian central banks buy dollars because they want to keep their own export-oriented economies competitive by making their own currencies cheap relative to the USD. OPEC and non-OPEC oil producers invest in US assets because they have so many petrodollars that they would be unable to invest all those dollars in other markets. Diversify away from the dollar, yes, but not stop investing in dollars until their own economies are quite a bit more developed and deep, liquid capital markets exist elsewhere.

For an example, you may look at Russia right now. They are suffering from a huge inflow into ruble markets, but there are not enough ruble assets to buy. The ruble is getting overvalued. The ability of the central bank to sterilize those massive inflows is limited. They have a policy problem (see Dutch Disease). You will notice that Norway, who faces similar problems, reacts by investing abroad. Hence why some of those petrodollars find their way back into dollar assets.

Besides one man's current account deficit HAS to EQUAL another's current account surplus, so whether in dollars, euros, yen or yuan savings flow to cover borrowing and vice versa. Higher domestic investment means lower international investment. Higher domestic borrowing means lower international borrowing. You may be interested to know that Brazil will offer Real eurobonds again in 2007 for the first time in donkey ages. Because there is finally an external demand for Real assets again, and the eurobond market is an efficient venue for international investors. That means less Brazilian borrowing in dollars. Plus Brazilian exports in dollar denominated commodities and metals will enable them to pay down external dollar debt.

So largely the value of the dollar is out of the hands of the Fed or the Treasury. Its value is determined by foreign investors. Raising rates will only support the dollar if investors have faith in the dollar, and if dollar assets make a good return on investment after inflation. High interest rates a la Argentina and Turkey accompanied by high inflation and a weak currency does not attract sane investors. Insane investors eventually get burned by defaults and devaluations.

Asian central banks and oil producing countries will determine whether the US' current account deficits get covered by external funds or whether it will be covered by domestic savings and onshore investment. If by domestic savings and onshore investment then those purchases of US treasuries will be at the expense of investment in real estate, the stock market and consumer consumption. The deficit has to be filled somehow by someone.

A good way to scare away foreign investors, and have them lose confidence, is to print too many dollars and try to inflate away those debts, again a la Argentina and Turkey. Then the dollar would fall, foreigners would lose interest in US assets in any case due to inflationary pressures eroding real yields, and US savers and investors would demand higher real interest rates to plug the gap. That would stop economic growth outside of making interest payments for the US economy. A debt default would be even worse.

So inflation and interest rates are intertwined. As the Fed can only control domestic interest rates via Fed funds, ultimately he has no control over the external value of the dollar, international rates of growth or inflation abroad, or over the value of USD assets like treasury bonds. If the US government increases money supply they can only make those assets worth less in adjusted values, and therefore less attractive to foreign and domestic investors.

These factors mean that once the government paints themselves into a corner via high budget deficits they take away the Fed's ammunition over interest rates and money supply, and the value of US assets is determined by foreign central banks and foreign investors. In other words, the US' fiscal and monetary policy has been off-shored along with their manufacturing jobs.
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