Why the Fed Likes Inflation (And What it Means For You)

Why would the Federal Reserve Bank, who is holding interest rates at zero, be purposely trying to whittle away the purchasing power of savers in this country? Below are a few simple rules to understand how the Federal Reserve operates, why interest rates will likely remain low for a while, and why that’s good for stocks and commodities.

The remainder of this article can be found at the website Man Of The House.

You Need Skills to Pay the Bills

The economy has gone haywire and politicians and economists are in total disagreement as to what to do about it. Regardless, the key to getting ahead is to look at the world how it is, and not how it ought to be. The world is tilted toward those that are well-educated or highly skilled and jobs will continue to shift from classic middle-class occupations like manufacturing and back-office work toward technology, education, health care and leisure services. There are two choices: complain about the trend or join it.

The remainder of this article can be found at the website Man Of The House.


Catalyst Investors Blog: Real Time Bidding and the Rise of Mid-Tail Content

For those of you interested in online advertising technology, my colleague Susan Bihler and I have written a two-part series on the Real Time Bidding ecosystem and its effects on online and offline media. The second part is a discussion about how RTB will help the Mid-Tail publisher, how RTB will hurt traditional TV and cable advertising and how Google is well-positioned to dominate the market. (click link to see the article)

Market Review: Beware an Emerging Markets Inflation Crisis

Right now the only assets that aren't overvalued (according to my model) are long term treasury bonds and long term municipal bonds. You can be confident that this is likely true because it feels the most wrong. Global monetary policy is supporting stocks and commodities right now, even though they are artificially overvalued, and they should be expected to keep rising until the policy trend comes to an end. We should expect the trigger event for the next market takedown to be an emerging markets inflation crisis, which would cause the existing global policy trends to go in reverse.

Fixed Income predicts continued malaise

The bond market has changed very little from the end of 2009, although there was a wild ride in between.

(Data from Bloomberg.com, Vanguard Funds, Economy.com)

The fixed income market is telling us that the Federal Reserve will likely keep the Fed Funds rate very low for at least two years and maybe more. Policy should be normalized sometime between year 2 (2013) and year 5 (2016). After year 5, however, the market expects an extended period of higher-than-equilibrium interest rates all the way through year thirty (2041).

While the Fed's bond-buying program may be affecting the short-to-intermediate end of the nominal treasury curve, the Fed is not manipulating the inflation-protected market ("TIPS") which are pointing to low real interest rates and a return to normalized inflation after only several years of aggressive monetary policy.

The basic message that the market is sending is that the economy and the financial system will underperform for at least the next two years. This is consistent with my view that housing will remain weak through at least 2012. Housing weakness affects the collateral values that underpin most consumer and small business lending. Thus the deflationary undertow of real estate on the financial system will weaken both the supply and demand for these certain types of credit.

Housing remains overvalued

The Case-Shiller house price index points to real house values being 5-10% overvalued relative to their long term trend (which is about 100).

The Fed Gets It

The Fed understands all this, however. The Bernanke Fed is performing quite well under the extreme circumstances. All the hoopla blaming the Fed for inflation (which so far is showing up only in commodity prices), is misplaced. The real culprits in grand market manipulation and inflation-creation are the central banks in emerging market economies. They are refusing to rein in monetary policy by the proper amount because they don't want to let their currencies appreciate and potentially weaken their export-led growth models. It is rapid demand growth in emerging markets that is driving up commodity prices, not overheated monetary policy in developed markets.

The "Virtuous" Market Circle

So now we have a policy framework that is about as beneficial for equity and commodity markets as possible. Weakness in the real estate and banking markets in the developed world result in low interest rates. Corporate America, which is relatively unaffected by the real estate markets, is racking up profits as emerging markets expand and productivity surges. Emerging market policy makers are over-expansive for fear of hurting their export machines. Emerging market central banks thus purchase developed world assets, keeping interest rates low and asset prices high.

Stocks are still overvalued – but may remain so for a while

The S&P 500 is priced to deliver only a 6.6% long term return today.

Earnings are well above trend, as the playing field is tilted in favor of multinational companies at the expense of labor and small business. If domestic or foreign government policy toward multinationals was to change, today's record margins would shrink and earnings would return to their long term trend level.

This policy mix keeps interest rates artificially low, stock and commodity prices artificially high, and is artificially holding up housing prices. Stock prices are probably only one recession away from becoming cheap, however.

Historically, earnings yields (inflation-adjusted trend earnings divided by the S&P 500 level) in excess of 6% imply a safe time to buy stocks with a long-term buy-and-hold strategy. We're not quite there, but should expect the end of the secular bear market that began in 2000 to come with the next recession.

Beware an Emerging Markets Inflation Crisis

What would bring the policy circle to an end would be an inflation crisis in emerging markets, which would force them to let their currencies appreciate to slow their overheated growth. While this change would put an end to the great economic imbalances that bedevil the global economy today, a sudden policy reversal could be very disruptive. Interest rates and the dollar would rise and stocks and commodities would fall as liquidity dried up. My recommendation to world leaders would be to start making the necessary adjustments now. This is essentially the argument that the US and EU have been making to the likes of China for years and it has been falling on deaf ears. For now, the Fed will continue to stick it to the emerging market central bankers and stocks and commodity prices will continue to rise.