The Federal Reserve will not be raising interest rates for quite some time. When inflation takes off, I believe they will let it go for a while.

Asking Price: $649,000
Address: 1 Blackswan Irvine, CA 92604
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Extreme ways are back again
Extreme places I didn’t know
I broke everything new again
Everything that I’d owned
I threw it out the window; came along
Extreme ways I know will part the colors of my sea
perfect colored me

Extreme ways they help me
They help me out late at night
Extreme places I had gone
That never seen any light
Dirty basements, dirty noise
Dirty places coming through
Extreme worlds alone
Did you ever like it planned?

Extreme Ways — Moby

During the Cold War, we were taught to believe that centrally-planned economies like Communist Russia or China were bad. The Cold War economy in Communist countries was certainly awful, and the Great Leap Forward did cause millions of people to die a preventable death of starvation. The toll a centrally-planned economy takes on its citizens is enormous.

We like to think our economic system is superior here in capitalist America. Capitalism is certainly superior to Communism at delivering goods and services to the populace, and it is unlikely that millions of people will die of starvation during the Great Recession; however, we have our own version of central planning with the Federal Reserve. We do not have a free market, we just have a lesser degree of central planning and regulation than Communism.

We are starting to look more Communist every day:

• Federal Reserve is holding interest rates far below free-market levels.
• The US Government through the GSEs and FHA are also holding down mortgage interest rates.
• The US Government is providing tax credits to buyers to stimulate demand.
• Private lending outside of Government insured entities has declined dramatically.

Where is the free market? Don’t expect to see its return any time soon.

US Federal Reserve 1913-Present

The Federal Reserve in the US was formed in 1913. It was thought that central control of the currency would provide greater stability to our economic system and soften the extremes of the boom and bust periods the United States endured in the 19th century. The Federal Reserve didn’t prevent the Great Depression; some would argue it didn’t even mitigate the effects and may have even made it worse.

There is one thing the Federal Reserve has accomplished that is not in dispute; since 1913 the Federal Reserve has inflated away about 95% of the value of our currency as evidenced by the Consumer Price Index. Inflation is the theft of savings; it is a stealth tax on everyone. When money loses buying power, wealth loses value.

Price and Wage Inflation

When the Government measures inflation, they use the Consumer Price Index (CPI). The CPI measures the change in price of a representative basket of goods that is supposed to reflect the general level of price change in the whole economy (it isn’t very accurate). It is not measuring money supply (another measure of inflation), economic growth or anything else; the CPI measures changes in consumer prices. So what causes prices to go up?

Prices can rise for many reasons, but there are two I want to examine closely today; currency devaluation and wage increases. If the currency declines in value, foreign goods become more expensive to import, and prices rise. If wages go up, people have more money to bid on goods and services, and prices rise. A wage and price spiral coupled with a devaluation of its currency is a dangerous economic trap. Argentina, Brazil, Chile, and Mexico experienced these conditions in the 1980s, and Argentina experienced another in 1998-2002.

Devaluation of currency has the biggest impact on a population’s standard of living. A decline in foreign buying power means fewer imported goods for consumption. Without increases in wages, people learn to live with less. This is the road we are heading down.

Deflation

When the credit crunch hit in August 2007, the Federal Reserve responded by lowering the interest rate from 4.75% to 0%. When interest rates first went down, so did the value of our currency. This caused a brief episode of inflation followed by the ravages of deflation due to the losses in the lending industry from The Great Housing Bubble.

The primary cause of deflatioin is the destruction of money through bank losses. When banks lose money, it ceases to exist. Fewer dollars chasing the same amount of goods and services makes for an increase in buying power; deflation. Greater buying power sounds good, but the spectre of a deflationary spiral like the one that caused the Great Depression is very real.

What Would Ben Do?

Ben Bernanke has written a number of scholarly papers in his life as an academic. He is drawing on this research to weather
this storm in our financial markets. He will likely keep the Federal
Funds Rate as low as he can for as long as he can in order to avoid repeating the mistake policymakers made back in 1937. The Federal Reserve will not raise interest rates in the face of increasing inflation — at least for a while.

If we assume the Federal Reserve will allow inflation to take off — something which it is not supposed to do — then how bad will they let inflation get, and why would they do that?

The first argument the Federal Reserve will make is that the CPI is “behind.” In other words, the deflation we experienced has left the CPI at too low a value. We need inflation to revive the economy with inflation just like we did in 1933. I think this argument is specious, but the Federal Reserve will make it anyway. It is unlikely the FED will be afraid of inflation until well after the crisis passes.

To “catch up” with what inflation should be — at least in the eyes of the Federal Reserve — how high might inflation get?

The actual rate of inflation at the peak is anyone’s guess. The Federal Reserve will allow it to go up until long-term inflation expectations begin to rise significantly or until the member banks of the Federal Reserve are solvent again. Solvency should take until the first or second quarter of 2010; if banks earn $250,000,000,000 per quarter, it will take them a year to make the $1,000,000,000,000 is is speculated they lost in total.

Making Up for Deflation

I am projecting a 12% rate of inflation as measured by the CPI in the summer of 2011. It will not peak until the Federal Reserve raised the Federal Funds Rate, and I as I outlined above, that is not going to happen soon. This will lead us to the second argument I believe the Federal Reserve will make; we need to “make up” for deflation.

Since we were behind the desired rate of inflation for so long, the Federal Reserve will justify the high inflation rate by claiming we need to get back to normal levels. This argument is also ridiculous, but it is what I believe the Federal Reserve will sell to us.

The result will be medium-term price inflation.

Long-Term Inflation Expectations

The Federal Reserve does not want to allow the world to believe that they have lost control of inflation again. If long-term inflation expectations become elevated, interest rates will go sky high just like they did in the 1970s. Unfortunately, when Timothy Geithner went to China to make the case that we will not inflate away our debts, the Chinese actually laughed at him. Can you imagine that? A US official has to tell a lie so transparent that the audience actually laughs?

Homedebtors will like inflation because the value of the currency they will be repaying has declined in value. Lenders hate inflation, and so do the wealthy. The Federal Reserve will do everything in its power to control long-term inflation expectations.

Impact of Medium-Term Inflation Spike

High inflation will burn off the mountains of bad debt we created during the Great Housing Bubble. We have a problem of insolvency. The only ways to solve it are (1) to increase people’s ability to pay, or (2) decrease the value of the money repaid. Since wages are not going up in the Great Recession, the value of currency must decline for the insolvency problem to be solved.

The net effect will be a lowering of our standard of living. When inflation is running at 8% and you get a 3% raise at work, your buying power has actually decreased by 5%. It looks like you are getting ahead because your pay increased, but in reality, you are falling behind and your standard of living is declining. The slow erosion of US buying power will be transferred to China as the country develops and local wages move higher there.

Since home prices are linked to wages, high inflation as measured by the CPI will not cause home prices to rise.

Real Estate is not necessarily an Inflation Hedge

The old adage about real estate being a hedge against inflation needs to be refined. Real estate as an asset class is a great hedge against wage inflation but not necessarily against price inflation. Since price inflation can be caused by wage inflation, people do not see that there is a distinction between the two. It is possible to have price inflation without wage inflation — which is what we will see from 2011-2014. When there is price inflation without wage inflation, our standard of living declines.

Government Conspiracy

I find most conspiracy theories to be crazy, but there are times when our Government lies to us, and we feel good about it. Every national recession is greeted with denial until the crisis is past. As a people, we like being lied to; if we didn’t, we would stop electing politicians we know to be liars. There must be a greater good that comes from the nonsense.

For instance, the Warren Commission reported that John F. Kennedy was assassinated by a lone gunman, Lee Harvey Oswald. Many people believe this is not true. Why would the Government lie? Well, let’s assume that JFK was assassinated by a Cuban-led hit squad, and that we learned the truth almost immediately. If the government lets this information out, we would probably have invaded Cuba (rather then embargoing them for 50 years). In the wake of the Cuban Missile Crisis, this would have started World War III. Do you tell the American public a flimsy lie about a President’s death? or do you start WWIII?

When we look back on the actions of the Government and the Federal Reserve in their handling of this crisis — which has either been necessary lies or gross incompetence — some will conclude the lies told by our officials was necessary and appropriate. The general public cannot handle the Truth.

Asking Price: $649,000

Income Requirement: $122,873
Downpayment Needed: $129,800

Purchase Price: $530,100
Purchase Date: 9/4/2009

Net Gain (Loss): $79,960
Percent Change: 22.4%
Annual Appreciation: 390.1%

Address: 1 Blackswan Irvine, CA 92604

Beds 3
Baths 2 baths
Size 1,506 sq ft
($431 / sq ft)
Lot Size 5,100 sq ft
Year Built 1976
Days on Market 7
Listing Updated 9/18/2009
MLS Number P703830
Property Type Single Family, Residential
Community Woodbridge
Tract Pt

This is a beautiful 3 bdrm/2 ba home with all new interior/exterior paint, new carpet, new kitchen appliances and new landscaping. Home is ready for move-in.

Do you wonder what happened to the bigwigs from IndyMac? Some of them have gone into flipping houses…