Monday, May 2, 2011

In the face of high prices for practically everything these days, the evils of inflation deliver a tough lesson in every trip to the cash register.

Inflation is, after all, a pervasive danger that's hard to stop once it gets started.
That's because run-away costs destroy the very price stability that markets thrive on. Without them, there is nothing but market chaos, since rapid price fluctuations in one market inevitably wash over into other areas, swamping them as well.
That's why the folks at the Federal Reserve talk tough about inflation once in a while, even if they don't really mean it.
It's the one part of their mandate they'll bend over backwards to turn a blind eye to.

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The problem with this approach, however, is pretty simple...
When the Fed chooses to pretend inflation doesn't exist, it opens up a Pandora's box.
Of course we all know the story of Pandora...
According to the Greeks, she was the first woman. Zeus sent her down to Earth with a box of troubles in her suitcase to get even with those rotten men. Before leaving, he told her one thing: "Whatever you do, don't take the lid off of that box I gave you."
Not long after, Pandora did just that and the evil the box contained was let loose on the world.
Now fast forward a few thousand years, and the Federal Reserve has done practically the same thing.
A decade of monetary hi-jinks has unleashed a pestilence of its own...
And with food and energy prices going through the roof for the second time in three years, the Fed has now given us a problem that can't be easily reversed. Price inertia, after all, has a ripple effect.
But that is the kind of market-wrenching unpredictability that you turn loose when you decided to purposely create inflation. It's impossible to contain in the short term — sort of like a bad 70s rerun.
Bernanke & Co., however, seem to dismiss this scenario, since it runs counter to their Keynesian notion that slower growth inevitably leads to lower inflation.
But it won't, because it ignores reality.
Here's why: A growing economy doesn't explain every instance of inflation. It never has.
Just look at the 90s... It was a period of enormous growth, yet there was very little inflation. Prices should have soared, but they didn't.
And look also at the 70s — the last time our economy tangled with stagflation. The period was marked by soaring unemployment, little or no growth, and rampant inflation. The conditions were so bad they gave birth to The Misery Index, which is making quite a comeback these days.
So you see, the magical checkbook isn't as wondrous as it appears. And in case you haven't noticed, the printing presses have been pumping out a tsunami-sized wave of greenbacks for years now.
Of course, all along this road, the U.S. dollar gets cooked and cooked and cooked some more along with your purchasing power. Yet the comical illusion goes on since the national scorecard — also known as the DOW — keeps climbing.
Just like Pavlov's dog, we like it when the markets are green... even if the only reason to salivate is a falling dollar. We are stupid like that.
But it's all connected. The high prices behind stocks, oil, gold, and the food in your grocery cart are all due largely to a devalued greenback. It's where cause meets effect. The chart below is what I call "The Chart That Explains It All":

As you can see, the DOW is neatly correlated to the falling greenback, which in this case is represented by UUP, the Proshares Bullish Dollar ETF.
So yes, the Dow is up over 10%. But the dollar is off by an equal amount — meaning you've really gained nothing at all. What is given with one hand, in other words, is taken away by the other.  It's smoke and mirrors.
But this monetary magic show has its limits — especially now that oil has crossed the $112/barrel mark.
At those levels, energy costs have now gone past the magical 6% of personal consumption mark, which history tells us is a prelude to tough times. Of the six United States recessions since 1970, all but the "9-11 recession" have been triggered when energy prices crossed this threshold.
What may make matters worse this time around is there has been a steep increase in food prices as well, with food prices rising 6.5% since January.

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