Interest Rates Foresee No Inflation

(10-18-09 update)
A run away inflation train is what many believe we'll see resulting from tons of USA money printing and borrowing.

Many of us recall the rising inflation days of the 70's exploding into ultra high interest rates that peaked around 1981. But if history is to repeat itself then we should be seeing rising interest rates in 2009 not declining (or stable) rates. And our governments selling of 30 year bonds at less than 1/2% interest rates to investors (during the fall 2008 financial panic) was the shrewd financial move of this decade. What does that make the buyers of those bonds? Can you say...fools.

The charts below show no rising interest rates (for now).

The times, as Bob Dylan sang,"..they are a changing" and someday we (USA) may have hyperinflation or stagflation again. But for the next year just expect Japanese style stagenation. After all, if the Japanese can be in a 20 year stagnation cycle of low inflation and low interest rates why can't the USA have the same. Japan has even had much lower average unemployment than the USA with low inflation. But wait, I'm forgetting one gagantic detail. Our excessive national debt. True that will come into play but I'm perdicting later not sooner.

The countries with the greatest potential for inflation are India and China. But they can view that as more a sign of their positive economic outlook and growth from much lower GDP levels of 20 years ago.

Why has the USA market continued to climb?

Less market fear and lower interest rates combined with some economic green shoots has resulted in the greatest American market bounce back since the 1930's. And lower corporate borrowing cost and slashed employee staffs mean higher future profits for large corporations even if revenues do not grow.

Forget what you want to believe and examine the data. During the 70's and 80's interest rates rose and fell but as you see in the charts below the trend was rapidly rising. This is the opposite trend of what we've experience over the last 20 years. So, while traditional beliefs may not have changed clearly the data shows something has changed. So what has changed?

What causes inflation?

Milton Friedman noted, “Inflation is always and everywhere a monetary phenomenon....It is a situation in which too few goods are being chased by too much money". The monetary policy is as lose as it gets. Economic's teaches us that inflation has two key drivers. #1. Cost-Push Inflation, workers’ ability to negotiate higher wages for themselves and business ability to raise prices. Rising commodities prices and product shortages can also cause this problem. We have neither. #2. Demand-Pull Inflation, resulting from an increase in aggregate demand, caused by an increase in money supply and increases in government and consumer purchases. We have both with one big exception. Consumer spending is only modestly recovering.

True, government gifts for spending like Cash for Clunkers $4,500 and $8,000 for first time home buyers resulted in a spike in spending. But at this point no bear or bull nor economist believes consumer spending is rapidly rising.

Therefore the U.S. monetary policy will (most likely) maintain the Fed-Funds rate under 1% through 2010. You can thank (or curse, if you have large amounts of savings earning near zero rates) our governments for keeping rates low like they did in 2001-2004. But unlike 2001-2004 we have record breaking amounts of unemployed and under employed people. And the (2001-04) housing building and spending boom is now bust. So, I'd bet we'll not see any meaningful spike inflation until late 2010.

What about our gargantuan national debt?

There’s also the inconvenient truth of U.S. debt, running up such gargantuan fiscal liabilities, both privately (consumers) and publicly. And just like the 70's once again were spending a fortune on war and the military. This time it's in Iraq and Afhganistan. Combine this with our future social security and medicare liabilities. No question we have long-term issues that could result in rapidly rising future inflation. The only hint of big inflation now is oil prices. Oil prices are now inversly correlated to the value of the dollar more than world demand and supply factors. Still one big variable has changed from the 70's that is keeping inflation low.

One big change from the 70's. One word. CHINA.

Yes, our enemy for 35 years has evolved into the worlds factory for cheaply built products (thanks to it's inclusion into the World Trade Organization). China has become our banker and product supplier. We have become their most important export market. We are their consumer market.

Why all the worry over China's willingness to lend us money? Why the worry over China dumping dollars? Why the worry over China wanting to cash in their USA treasury bonds? Folks, forgive my bluntness but these are nonsense worries (if only in my mind). It's like saying we need to worry about drug dealers not wanting to sell drugs for profit and employment to drug users.

I hear a few people saying: what is this Madman-Across-The-Water saying?

Think about this. The USA is China's number one export market. China will gladly work to keep us (and the world) addicted to buying their goods to keep their labor force employed. And do you really believe that China wants to kill the U.S. Goose that lays their golden eggs? No. Just because you're a Communist does not mean you're an Economic Neanderthal Man. There's no better way to beat a Capitalist then at his own game and on his home field!

30-Year Conventional Mortgage Rates, 1971-2009:


30-year Treasury bond yields, 1977-2009:


Baa Corporate 30-year Bond Yields, 1962-2009:


AAA Corporate 30-year Bond Yields, 1962-2009:


Prime rate, 1955-2009:


Dr. Mark J. Perry is a professor of economics and finance in the School of Management at the Flint campus of the University of Michigan. He (and many other economist) have pointed out that historically low 30-year mortgage rates reflected relatively low market expectations of future inflation. Some commenters (and Robert Shiller on CNBC) pointed out that the Fed is buying mortgage securities, which is temporarily keeping 30-mortgage rates low, rather than low inflation expectations keeping rates low.

What we believe and what is, are often two sides of a coin.

But the charts above show that other long-term rates (30-year Treasury bond, 30-year AAA corporates and 30-year Baa corporates) are historically low, as well as the prime rate being historically low, and these low rates wouldn't necessarily have anything to do with Fed purchases.

Question: How could all of these long-term rates be so low if there were inflationary pressures building up in the economy, which would lead to higher expected future inflation, and higher nominal long-term interest rates, and not historically low long-term rates?

We each have different inflation rates.

Now when it comes to inflation, each person or family will have a different index based upon what you must buy and want to buy. If you are an older American family, whose house was paid off years ago and who now needs to spend large sums of money for health care and college education (for your children or grandchildren) then your real inflation rate is sky high.

If you are young with no health care expense and renting or buying a home at today's ultra low mortgage rates along with lots of fantastic electronics goods at excellent low prices your inflation rate has been declining dramatically from 20 years ago. In the 70's I recall getting annual letters from my landlords explaining why due to inflation my rents would be rising by 7% even thought 85% of the landlords ownership cost in the property were fixed. But everyone just came to expect rising rents. Today rents have not only been level but in many cases they had to declined to keep renters. Each person or family's situation will be different.

But while each person's inflation index will be different, in aggregate the USA CPI is still the best gage of our nations inflation rate (consistently applied over time). I would agree with the debate that we need to examine the relevance of the variables making up the index to our lives and required expenditures' vs. desired expenditures'.