Monday, June 23, 2008

A Losing Battle: Inflation Takes Control

While the effects of the housing market implosion continue to ripple throughout the economy, the Federal Reserve resorts to its favorite bailout strategy of cutting the fed funds target rate. The slightest sign of weakness in the US economy prompts the Fed to blindly jump to action even as more prudent heads prevail in Europe. Both the bailout of the technology bubble and the ongoing rescue of the housing implosion injected massive amounts of liquidity into the economy leading to market distorting behavior. The original liquidity infusion following the bursting of the tech bubble started the dollar on the slippery slope of devaluation against the world’s major currencies. Weakness in the dollar combined with the global commodities boom resulting from the industrial emergence of China and India have affected a dramatic rise in core inflation that further threatens our fragile economic stability.

The structural imbalances of large trade deficits and significantly lower domestic interest rates debase the value of the dollar. As the dollar weakens, our globally integrated economy suffers as goods and services procured from overseas operations become more expensive to dollar based consumers. The raw materials, manufactured goods, and energy resources that are obtained from our trading partners around the world are ingrained in the American economy with suitable alternatives not immediately available. Large capital investments and extensive human resource development would be required to provide substitutes for the products and services that we import. Such endeavors would require years of investment, deferring any anti-inflationary effects and mitigating the benefits of a reallocation of resources.

The rapid growth in emerging market economies combined with a lack of foresight and planning by the largest energy consumer, the United States, has seriously constrained the system and destabilized global prices. While politicians try to deflect the blame by “investigating” price manipulation, speculator impact, and “excessive” corporate profits, they are neglecting any real solutions and postponing serious responses to the problem. Environmentalists and politicians prefer to focus on “alternative energy” while ignoring the fact that, despite significant investment, wind power contributes only 1% and solar 0.01% to electricity production. This suggests that there are no realistic short term alternatives to carbon based and nuclear energy. The growing demand for scarce resources, which will only accelerate with China and India’s ongoing industrial revolutions, is a threat to global economic stability and subjects economies to drastic price shocks in commodities and energy. The price of coal is up over 6% since the beginning of June and instability around the globe threatens oil supplies from the Middle East and Africa. Additionally, the U.S. uses 10-20 times more oil per capita than developing countries such as China and India portending significant future demand as these nations further develop and desire energy intensive “luxury” goods. Absent domestic responses to these issues, the stability of the United States’ economy will continue to erode with greater risk of price spikes, rolling blackouts, rationing, and hoarding of basic commodities and resources.

In order to combat the growing threat of dependence on unstable regimes for the lifeblood of our economy, it is essential that the United States make significant domestic investments in a diversified energy portfolio and eliminate sources of inefficiency in the global market for food and agricultural commodities (e.g. import barriers, farm subsidies, quotas). Despite opposition from various activist groups, policymakers must approve and facilitate the construction of new nuclear and clean coal power plants to leverage our domestic energy resources. Alternative energy resources such as waste to energy facilities and wind power should continue to be encouraged as a means of utilizing natural sources of energy in a more efficient manner. With the United States’ electric grid operating in fragile balance and new electric production capacity trailing demand increases, electricity will likely become the next commodity to inflict serious economic damage. The regulated nature of the electric utility industry limits participants’ ability to respond to market forces through investment in new facilities or through market based pricing. The fragility of the electricity grid is disguised by excessive regulation which will lead to significant bankruptcies, operational disruptions, and system failures if wholesale energy prices were to spike again as they did in the early part of this decade.

The political agendas of misguided special interest groups combined with a lack of initiative in Congress has led to a global commodities and energy crisis that threatens economic stability and increases inflationary pressures. While many companies have resisted the urge to pass along costs increases to the end consumer, they are no longer able to absorb the growing costs that result from commodity and energy price spikes as well as increases in raw materials import prices. Cost push inflation is growing at a rapid pace as demonstrated by dramatic increases in airline ticket prices, grocery bills, shipping costs, and gasoline prices. These costs will continue to trickle through the economy and, when combined with higher import costs, seriously debase American consumers’ spending power at a time when they are suffering from the housing crisis and dramatic constrictions in the access to credit. Political leaders must stand up to special interest lobbies and enact a comprehensive energy policy that focuses on energy independence, infrastructure investment, and diversity in procurement. Additionally, the Fed needs to raise interest rates to protect the dollar despite further risk to economic growth. Failure to address these issues will relegate the U.S. economy to substandard growth, increasing inflation, and regular price spikes and supply disruptions in both energy and food commodities.