The Fed Has Won the Inflation Battle

09/09/2008 12:00 am EST


John Dessauer

President, John Dessauer Investments, Inc.

John Dessauer, editor of John Dessauer’s Investor’s World, says conventional wisdom is wrong and inflation is going down.

The headlines tell us that the cost of living in the United States was up 5.6% in July 2008 (vs. July 2007), the biggest 12-month jump in 17 years. Oil has pulled back, but the crowd is still terrified that inflation is about to add to our already-long list of financial miseries.

The crowd assumes this means the Federal Reserve has lost the battle against inflation. But the crowd is 100% wrong. The Bernanke Fed is doing all the right things. Inflation is headed lower. That will bring interest rates down, and lower mortgage rates will boost home sales and the economy.

House prices are down. That has reduced household net worth by $1.7 trillion. This is not
inflationary; it is deflationary. The world economy is suffering. Japan’s economy contracted 2.4% in the second quarter. Europe now faces a recession. The US economy has also slowed dramatically. This is clear from the falling current-dollar (nominal) GDP growth rate. The US economy has been in a slow-growth anti-inflationary environment for almost a year now.

Oil is down 25% from its mid-July peak. Gold fell $200 per ounce (20%) in one month. Most other commodities are also down and, to the surprise of many, the dollar has rallied.

The most significant aspect of the dollar rally is that it confirms that we are heading for lower inflation. The Bernanke Fed has won the battle against rising oil and food prices. We saw it coming because we watch US money growth, which has remained subdued. That’s why the core rate of inflation did not soar as it did in the 1970s.

In the early 1970s, the mid-1970s and the early 1980s the growth rate of M2 spiked up to 12%. Inflation is a monetary phenomenon. It was those sharp increases in the rate of growth of M2 that allowed inflation to rise to 13%. For the past three years, M2’s growth has stayed between 4% and 7%. Moderate growth in M2 denies the economy the fuel required to produce broad-based inflation. Since money growth is and has been much slower recently, it follows that inflation will also be much lower.

Where will oil find its new bottom? It is likely that speculation caused oil to overshoot on the upside and now, as the speculators run, the price may overshoot on the down side. Oil can fall below $100 a barrel, perhaps all the way back to $80, where some experts think it should have been all along.

This constellation of economic forces points to significantly lower inflation ahead, and lower inflation means lower long-term interest rates.

As inflation rates fall, the fear of future inflation will subside and the 30-year home mortgage rate will fall back below 6%. Combine lower mortgage rates with lower house prices and you have the ingredients for a revival of the real estate market.

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