While the Federal Reserve has been cutting key interest rates since late summer in an attempt to ease fears of a liquidity crisis (a stark contrast to “the world is awash in liquidity” sentiment heard so frequently earlier in 2007), some of the negative side-effects of the rate cuts have started to become evident. Mainly, a larger-than-expected jump in key areas of the Consumer Price Index (CPI). These areas include the cost of clothing, airline tickets and prescription drugs. The jump in pricing should not come as a huge surprise to anyone who has taken a basic macroeconomics course, nor to anyone who does the shopping for a household.

Inflation is a widely debated topic amongst economists and many do not agree whether inflation is detrimental to the economy or not. While many argue that money is neutral in the long run, most of us don’t live in the long run and prefer that our dollars remain a good store of value. One thing even economists generally agree on is that rapid inflation is very detrimental and is a clue that the economy has underlying problems. While “high inflation” typically has different meanings depending on where you live - and we aren’t anywhere near real hyperinflation - having CPI come in above a 5.5% compound annual rate certainly qualifies as high relative to what is expected. With this latest report showing a higher jump in prices, it brings into question how much room the Federal Reserve has with further rate cuts if they wish to keep inflation at a low rate.
Barry Ritholtz suggests that there will be no chance of a 50 basis point in rates unless the Fed panics. On the other hand, Jim Cramer suggested on CNBC that the Fed should cut rates even further because ultimately the dollar will respond to the fundamental strength of the economy, not short-term interest rates. While both present good arguments backing different viewpoints, the Fed cannot ignore inflation and as such they should not be overly aggressive in lowering interest rates. Cheap money started this housing mess, so how will it fix it?

With inflation likely to be rising as the Federal Reserve is forced to keep interest rates low, so realize that moderate inflation, while devaluing the purchasing power of your money, is not something that should seriously alter your investing strategy. Do analyze your portfolio and take into account what the current rate of inflation is, but in most cases the rate of inflation is mild enough not to force an investor to make any dramatic changes to their holdings.

So as we look forward, remember the very basic things that we learned in entry level economics classes - as interest rates are lowered, the inflation rate will rise. This will not impact most equity investments. Look at what events in the future will drive interest rate and inflation changes, and adjust accordingly. Personally, I am looking closely at how the Fed will balance credit problems against the need to keep inflation low, while also monitoring the yield curve. Of note there, long-term rates have held steady while short-term rates have come down greatly; the net result is a 50% increase in the 3-month/10-year Treasury spread in the last month, which could certainly help the money center banks make something back on deposits to offset losses related to writedowns.

Subscribe to our feed: