The Fed, Inflation and Housing

* Ben Bernanke testified in front of Congress yesterday, and covered a range of topics. One Congressman asked Ben if creating inflation was a solution to the current economic situation. Ben remarked that it was not, because too many government expenses are indexed to inflation, and that inflation would feed on itself in a non-productive way. It was comforting to hear these words come from the Fed Chairman. This leaves me trying to sort out how this country is going to escape the gravity of the deflationary headwinds running through our economy. Can the Fed feed enough monetary stimulus into the economy to offset the deflationary headwinds which are prevalent? The short list of deflationary markers are (1 year rates of change through 12/2009):


Bank Balance Sheets     - 730 billion

Bank Lending    `       - 640 billion

Consumer Credit         - 110 billion

Housing                 too many statistics to list

Household Wealth        -  12 Trillion (last 2 years)

Unemployment            + 2.3 million (those collecting unemployment insurance                                         - last year)

                         +7.4 million (last 2 years)


The bottom line is that the Fed has much to worry about, which creates plenty of camoflauge for them to keep interest rates low for quite some time.


* CPI – Yesterday’s CPI report reflected the topsy turvy nature of the current inflation paradigm. Here are some excerpts from the report:


Component              1 yr Change     Share of total CPI

CPI                       +2.3%            (100%)

Food                      +0.2%            (13.7%)

Energy                   +18.3%            (8.55%)

CPI less Food & Energy    +1.1%            (77.7%)

Housing                   -0.6%            (42.0%)

All Items less Shelter    +3.8%            (67.7%) (*)


(*) Because Housing includes some aspects of energy costs, and other contributions, all items less shelter does not equal 58%, as these other items are added back into this reading.


Housing is the 600 pound gorilla in the CPI index, and will provide cover for the Fed to maintain their easy monetary policy.  In fact, it is possible that housing could take another leg down, which would provide further deflationary pressures on the economy, and keep CPI under control.


Interestingly enough, CPI less housing is actually up 3.8% in the last year. The biggest driver of this expense is energy costs. The data shows that the BRIC countries consume a very small amount of oil on a per capita basis, and there is a likelihood that car ownership and other consumption measures are likely to rise dramatically in these countries. This points to a future of growing oil demand. In other words, oil prices are likely to rise, which should continue to feed a lopsided CPI report in the future. The take-away is that despite what oil prices do, there should be still be plenty of cover from a weak housing market to give the Fed a pass to keep interest rates low.


In my opinion, the key will be to orient your investing strategies to take advantage of a lopsided outcome in the CPI index, as well as corresponding demand factors in the various sectors which drive CPI. The big loser in my opinion is likely to remain housing.


So let me go back to Bernanke’s statement about fighting inflation. At what point will the Fed start to drain money from the economy and raise interest rates to fight inflation? If I go back to the deflationary factors in the economy, then I would say never. One one level, rising stock prices are helpful for those folks with enough money to own stocks, but on average, housing is a far bigger factor in the economy and contributes more to the country’s wealth effect. And with housing still off by a significant amount, and with the shadow inventory of supply, estimated at 7 million units by one analyst, I cannot see housing doing better, (almost) no matter what. How does the Fed react to $5 a gallon gasoline, even if total CPI remains around 2%? 


It was also notable yesterday, that Bernanke made note of the CPI measure less food and energy, and with that at a very tolerable 1.1%, it is likely that CPI will never go up more than 2%, given that housing is half the ex food and energy index. 


My take-away for you today, is that the Fed might not ever need to tighten again, as long as housing remains muted and there is a shadow inventory of 7 million units waiting in the wings. There is plenty of roll-down in the treasury and euro curve if you go out 1 to 2 years for instance. I am also sure there are some slick bets we can make on inflation in everything but housing.