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Clive Roffey: If you don''t buy metals now, you''ll hate yourself in six months

Section: Daily Dispatches

Low Rates, High Expectations

By James Grant
The New York Times
Sunday, May 16, 2004

http://www.nytimes.com/2004/05/16/opinion/16GRAN.html

Inflation is returning to the American checkout counter
under the unlikely sponsorship of the Federal Reserve.
For the past year, the Fed has been striving to make
the dollar buy less. It's well on its way to succeeding,
to judge by the recent readings on wholesale and
consumer prices.

Why the Fed decided to propagate inflation, after
having so long battled against it, is a story that
begins with the return to common usage of an old
word. Late in 2002, officials began to warn of the
danger of "deflation," or broadly falling prices.
Everyday low prices are well and good, the central
bankers allowed. Yet if prices steadily and
predictably fell, people would stop buying things.
They would stay home to wait for tomorrow's
guaranteed lower prices. And if the American
consumer stopped shopping -- and borrowing to
shop -- where would we be?

So, last June 25, the Fed pushed the federal
funds rate, the rate it directly controls, down to
1 percent, the lowest since the second
Eisenhower administration. And it warned that
"the probability, though minor, of an unwelcome
substantial fall in inflation exceeds that of a
pickup in inflation from its already low level."

Before the Fed was founded, in 1913, there were
recurrent cycles of inflation and deflation. In
general, prices rose in wartime and fell in
peacetime. In the last quarter of the 19th century,
prices persistently fell. Technological innovation
pushed down costs, and lower costs translated
into lower prices. Wage-earners flourished as the
spending power of money increased. Creditors
prospered too, as interest rates declined.

Then, about 1900, the world struck gold -- in
Alaska, Colorado, and South Africa. As gold was
then the monetary asset on which national
currencies were based, the world, in effect, struck
money. For the next two decades, prices went up.

It is a relatively new thing in finance that prices
should not be allowed to fall. The Federal Reserve
implicitly admits as much. On the one hand, it
extols the rising productivity of the United States
economy. On the other, it declares that this
extraordinary progress should not be registered in
falling prices. In so many words, the central bank
says that what is good for Wal-Mart's customers
is not necessarily good for the country.

The Fed doesn't literally print money. Instead, it
manipulates the interest rate that induces others
to print money. In a modern economy,
money-printing takes the form of credit creation,
i.e., lending and borrowing.

There has been a great deal of this in recent years.
By any and all measures, America is more heavily
indebted than ever before. In 1958, when the funds
rate was last at 1 percent, the economy's overall
indebtedness was about half of today's. Back then,
overall debt (excluding the borrowings of banks and
the federal government) represented 84 percent of
gross domestic product. Nowadays, it stands at
163 percent of GDP.

The weight of this indebtedness, foreign as well as
domestic, helps to explain why the Fed set its rate
so low. One percent is an emergency rate, unseen
before the institution of the Fed and only rarely since.
It was the rate intended to raise the economy from the
Great Depression and to see it through World War II
and the immediate cold war era.

The Fed chairman, Alan Greenspan, and his
colleagues keep saying that there is no emergency
-- that, on the contrary, the United States economy
is a paragon of strength, lacking only an acceptable
rate of job creation. Yet they have kept their rate at
the emergency setting, thus fomenting a real-estate
boom on Main Street and a stock-and-bond boom
on Wall Street.

Now the 1 percent era is fast closing, and financial
markets worldwide are shuddering. As the signs of
inflation multiply, the Fed finds itself in a very
interesting position. It never wanted much inflation,
it protests; just a whiff would suffice.

But the subjects in the central bank's monetary
experiment are human beings, not laboratory mice.
When people sense that prices are going to rise,
they take steps to protect themselves. They buy
extra inventory, invest in so-called hard assets
(houses, not bonds) and pass along their rising
costs as best they can. Once instilled, inflationary
habits are hard to break, as the Fed exactly
understands.

And the Fed will raise its rate, though grudgingly
and gradually. It will act in this fashion not only out
of conviction but also, perhaps, out of a guilty
conscience. It knows that its 1 percent rate drove
many risk-averse people into stocks and bonds
because they could no longer afford to live on the
meager returns of their savings. That is at one pole
of the spectrum of financial sophistication. At the
other, hedge funds borrowed at ultra-low rates to
speculate in everything from gold to lead. Just the
prospect of a slightly higher borrowing rate has
brought about disturbances in the temples of high
finance.

The Fed has another reason to be
conscience-stricken. It knows, or should know,
that by trying to make the dollar cheaper, it has
precipitated even more borrowing in an economy
heavily encumbered. The greater the debt, the more
deflation-prone the economy. And the more
deflation-prone the economy, the more the Fed is
apt to try to cheapen the dollar. The truth is that
the central bank of the United States is chasing
its tail.

------------------------------

James Grant is the editor of Grant's Interest Rate
Observer.

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