Trapped: The Fed Has Painted Itself Into a Corner

Fed Chairman Ben BernankeAs prices for commodities such as cotton, sugar and grains skyrocket, many financial commentators have been pointing the finger at Federal Reserve Chairman Ben Bernanke's "easy money" policies of zero interest rates (ZIRP) and quantitative easing (QE2) as a major cause.

The Fed intended these two policies to lower long-term interest rates and to nudge investors into riskier assets, thus stimulating growth. At least one part of that strategy is working. By lowering the yields on traditional financial investments such as bonds to near-zero, the Fed has essentially forced trading desks and hedge funds to scour the globe for higher yields.

Many traders and investors have found that higher yield in commodities, which is where speculative money is now flowing in abundance, helping to push up prices. Because the price of wheat, for example, is roughly the same everywhere in a global market, these rapid price increases are destabilizing poorer countries where much of household income is devoted to food.

Charges and Countercharges

Global demand for many commodities is outstripping supply, and that imbalance is a key factor in higher prices around the world. But a global economy awash in low-interest, speculative "hot money" seeking higher yields is further fueling imbalances.

Fed officials have faced pointed criticism from nations such as China and Germany, which see the Fed's policies as firing up inflation and suppressing the U.S. dollar. Fed Chairman Bernanke has countered these charges by identifying the problem as one of currency valuations. He suggests that other nations should offset rising commodity prices by letting their currencies climb in value.

Bernanke's protests, however, have a hollow ring: Clearly, skyrocketing commodity prices aren't just a currency-trade issue. For example, consider this cotton-price chart, which has "gone parabolic." Can anyone seriously claim that the "solution" to this situation is for China to allow its currency, the yuan, to appreciate? Is the yuan the real cause of wheat and corn both shooting up 80% in 2010?



The reason why Bernanke's claim is so transparently nonsensical is that commodities are rising everywhere, not just those originating in China. Despite official assurances that inflation in the U.S. is now running at a modest 0.7% annually, by one measure, it's actually hitting an annual rate of 2.5%. By another, it's already a white-hot 10.6%.

This chart shows how rising prices are built into the supply chain, with the result being costs of intermediate and crude goods are rising smartly.



Inflation is running hot around the world, not just in China and the U.S. This also suggests that the issue isn't one that can be resolved with currency adjustments.

Even though inflation appears to be lower in the U.S. than in other major economies, it's hitting the average U.S. household hard because wages aren't rising along with prices. Indeed, according to the U.S. Census Bureau, real median household income in 2009 was $49,777, a 5% decline from the 1999 peak of $52,388 (adjusted for inflation).

This is in marked contrast to nations such as China, where workers are gaining substantial raises (21% in Beijing, for example), to counter rapidly rising costs.

An Unbreakable Cycle


The Fed is being disingenuous in claiming it's blameless for global inflation. And in a larger sense, the central bank is attempting to repeal the business cycle. In the normal course of capitalism, low rates and easy credit lead to increased borrowing, which leads to rising consumption and investment in production to feed that increased consumption.

This leads to higher profits, which generates more investment and credit expansion.

At some point, the cycle hits a brick wall: Borrowers can no afford to pay more interest as rates rise, so debt stops increasing, and consumption and demand slump as borrowing levels off. In the rush to mint profits, production capacity now exceeds demand. And as a result, prices and profits both fall -- the natural consequence of excess capacity.

As the boom progressed, investors sought out riskier, more marginal investments. But as new debt and demand fall, these riskier investments lose money and are either shuttered or sold for a loss.

Then, as profits decline, workers are laid off, and commercial borrowers find their income streams aren't sufficient to meet their obligations. The credit cycle turns from expansion to contraction, as marginal borrowers go bankrupt and insolvent businesses and loans are liquidated or written down.

This purging of bad debt, speculative excess and misallocated resources lays the foundation for another cycle of renewed growth.

Credit Goes to the Wrong Hands


But the Fed is attempting to repeal this business/credit cycle. Rather than allow credit to fall sharply and interest rates to rise as bad debt is purged from the financial system, the Fed has pursued a policy of making credit even cheaper in the hopes that borrowers will be able to borrow more since rates are near-zero.

However, because consumers and enterprises are still burdened with mountains of existing debt and undeclared losses, few are willing or qualified to borrow more. As I recently wrote here, consumer debt in the U.S. has declined a paltry 2.7% in the wake of the Great Recession.

The Fed's quantitative easing thus ends up flowing not to households or productive enterprises but to the "too big to fail" banks and Wall Street firms, which then seek higher returns in assets such as stocks and commodities. The Fed's intention was to push money into productive growth, but instead it has fed pools of speculative money chasing high returns in global commodities. This is helping to fuel inflation in food and other commodities -- not just in the U.S. but globally.

In a Double Bind


Now the Fed has painted itself into a corner. If it keeps interest rates low and continues pouring hundreds of billions of dollars into "hot money" hands, it will be adding to the destabilizing forces of rising commodity inflation. If it stops its QE2 stimulus to help cool global inflation, then interest rates will rise, pushing marginal borrowers out of the market and increasing borrowing costs for everyone from new home buyers to Wall Street speculators. That could destabilize the fragile recovery and the bull market in stocks.

By attempting to repeal the business cycle and refusing to allow a necessary credit cleansing (writing off of bad debt) and repricing of risk, the Fed has created an inescapable double bind for itself: either continue pursuing easy-money policies and help destabilize the global economy with rising commodity inflation, or allow interest rates to rise and destabilize speculative markets and marginal borrowers.

Increase your money and finance knowledge from home

Professional Vs Do it Yourself Investing

Should you get advice or DYI?

View Course »

Bonds for Beginners

Learn about fixed income investments.

View Course »