Scientific research by Princeton university mathematical biologist Dr. Iain Couzin has revealed that humans, like ants, tend to swarm. His research found that the “human swarm” resembled others in that it made rapid and unconscious decisions. When discord arose, it tended to “follow the largest group of leaders, even if it contained one additional person.” The financial markets offer a good laboratory in which to observe such behavior at work.

In his memoirs, In An Uncertain World, former Secretary of Treasury Robert Rubin noted the swarming behavior that can take place when market psychology changes. He wrote, “[T]he psychology of markets is that investors who are far too complacent one day may quickly change and become a stampeding herd the next. In a world of instantaneous reactions, the tendency to react rather than to think is not necessarily irrational. In the race to an exit that not all will fit through, speed can be lifesaving…”

Such behavior is highly germane to the current housing-induced financial challenges now facing the nation. Previously, buyers swarmed into real estate as homes were seemingly transformed into ATMs on the crest of a rising bubble of valuations. Now, in the face of rising inflation and continuing interest rate reductions by the Federal Reserve, the proverbial swarm is increasingly beginning to flee inflation. Indeed for the last two days, the price of oil has risen sharply on account of inflation-hedging. Today, CNN reported, “Oil prices soared past $109 a barrel after rising to a record in the previous session as the U.S. dollar weakened further. Speculation that rising prices for oil and other commodities will offset the falling dollar has driven oil’s rally from $87 a barrel in January… ‘This surge to new records is driven by the speculative and large funds moving money into commodities. It’s primarily a U.S. dollar and inflation play by financial investors,’ said Victor Shum, an energy analyst with Pruvin & Gertz in Singapore.”

In effect, a growing share of the markets is increasingly is losing confidence in Fed Chairman Ben Bernanke’s commitment to price stability. That erosion of confidence actually began several months ago and then accelerated after January 2008.

If one examines the adjusted 10-Year TIPS inflation expectations published by the Cleveland Federal Reserve Branch, one finds that after November 7, 2007, inflation expectations that had largely been anchored in the 2.0%-2.5% range broke free (rising 0.341% on November 8) and settled above 2.8%. Since the beginning of March, those rates have fluctuated in the 3.40%-3.50% range.

Adjusted TIPS Inflation Expectations:

Source: Federal Reserve Bank of Cleveland

The interplay between the Fed’s increasingly accommodative monetary policy and rising inflation is crucial to understanding why the markets began to lose confidence in Mr. Bernanke’s commitment to price stability. The following are the dates on which the Fed made interest rate adjustments:

September 18, 2007: Reduced the federal funds rate by 50 basis points to 4.75%
October 31, 2007: Reduced the federal funds rate by 25 basis points to 4.50%
December 11, 2007: Reduced the federal funds rate by 25 basis points to 4.25%
January 22, 2008: Reduced the federal funds rate by 75 basis points to 3.50%
January 30, 2008: Reduced the federal funds rate by 50 basis points to 3.00%

During the August 2007 through January 2008 timeframe, the 12-month change in the Consumer Price Index (CPI) was as follows:

August 2007: +2.0%
September 2007: +2.8%
October 2007: +3.5%
November 2007: + 4.3%
December 2007: +4.1%
January 2008: +4.3%

The CPI for the preceding month is typically published at mid-month. Hence, the December 2007 CPI was published on January 15, 2008. Nevertheless, following a sizable jump in the CPI for September, there were growing expectations ahead of the release for October that the CPI might crack the psychological 3% threshold. It did. A month later, it had exceeded 4%.

Initially, perhaps largely on the credibility the Federal Reserve had accumulated under Chairmen Paul Volcker and Alan Greenspan, the markets assumed that Mr. Bernanke understood what he was doing. Hence, adjusted TIPS inflation expectations changed little at first. Only when the Fed continued to reduce interest rates even as inflation numbers were worsening did the erosion begin. At first, the expectations jumped but then held steady, perhaps under the assumption that the Fed would draw the line on inflation. That did not happen. Afterward, the inflation expectations really began to deteriorate when the Fed cut interest rates another 50 basis points after a 75 basis point cut just 8 days earlier. At that point, the markets appeared to reach the conclusion that the Federal Reserve had essentially abandoned its commitment to price stability and those expectations for higher inflation are, in effect, an increasing vote of “no confidence” in the Bernanke Fed.

These trends are seen in the average adjusted TIPS figures for the periods prior to and after the Fed’s interest rate moves.

August 1-September 17, 2007: 2.462%
September 18-October 30, 2007: 2.339%
October 31-December 10, 2007: 2.777%
December 11, 2007-January 18, 2008: 2.872%
January 22-January 29, 2008: 2.878%
January 30-March 11, 2008: 3.238%

In the past, the Fed’s combination of increasingly easy money in the face of rising inflation has been a recipe for more inflation and eventually a sharper economic downturn. The 1970s provide a case example of the dangers of such a policy.

In recent weeks, a number of the Fed’s governors have attempted to thwart rising inflation expectations with some governors publicly proclaiming the Fed’s continuing commitment to price stability. But the Fed’s overall message has been mixed. For example, Philadelphia Federal Reserve President Charles Plosser stated, “I believe we are in a situation where monetary policy cannot be made by focusing solely on inflation.” Which message should the markets believe?

Actions speak louder than words. Not surprisingly, the markets see the Fed’s credibility as an inflation fighter waning. Yesterday, Bloomberg.com reported, “For the first time in a generation, money managers must come to grips with a central bank that’s more intent on spurring the economy than restraining price increases.” “The way TIPS are trading now, investors believe headline inflation will stay lofty and are willing to give up the real yield for that,” Brian Brennan, a money manager at T. Rowe Price Group explained in that Bloomberg story.

Mr. Plosser’s commentary aside, the idea that one must choose between stronger economic growth and inflation is a false assumption. Inflation is a killer of economic growth. In 1989, then President of the Cleveland Federal Reserve W. Lee Hoskins explained:

In the long-run, there is no trade-off between inflation and recession. Ultimately, inflation itself causes recession and, inflation results in less than optimum economic performance. A monetary policy that strives for price stability, or zero inflation, is a pro-growth policy…

In the early 1980s we had recessions caused by monetary policy mistakes. The policy mistakes were the excessive monetary growth rates of the 1970s. This excessive growth of money in both Canada and the United States allowed accelerating inflation and rising interest rates that led to the need for disinflationary monetary policies. The disinflationary policies were necessary to get our economies back on acceptable real growth trends.

Former Federal Reserve Chairman Paul Volcker, who presided over the Fed’s successful efforts to quash the inflation that was bred in the 1970s from easy money, warned, “[s]eeking relief from financial pressures in renewed inflation would exacerbate a… major area of concern for central banking—the extreme volatility of interest rates, and even more, of exchange rates. The damaging effects on international investment, trade and ultimately productivity have been significant.” He continued, “Dealing with inflation: Certainly our collective experience strongly emphasizes the importance of dealing with inflation at an early stage, before it assumes a momentum of its own with deeply embedded effects on expectations.”

As historians have noted a remarkable ability of people to forget the lessons of the past, today’s generation of Fed policymakers appear to have forgotten the lessons set forth by Chairman Volcker and Governor Hoskins. Instead, the Fed has embarked on a course of reflation. However, there are no “free lunches” and the bill is already starting to come due in the form of expectations for higher inflation.

With inflation expectations now rising, the crucial question at hand is whether the Fed has, indeed, forgotten the lessons of the past, and will make itself into what former Fed Chairman Marriner Eccles once termed, “an engine of inflation.” If so, those expectations for higher inflation that are now reflected in the adjusted TIPS figures will, as Mr. Volcker warned, become “embedded.” Then, there will be an economic price to pay as inflation continues to mount. Interest rates would eventually soar and the recession to required to break the back of inflation could be a significant one.

Originally Posted by Iriemon Very good article, IMO. Of course, it's not fair to blame Bernanke for the mortgage loans situation; a product of lack of regulation and perhaps interest rates that were kept too low too long in the early 00s by his predecessor. And it's not his fault that the oil interests have prevented any meaningful energy policy, which left the nation unnecessarily vulnerable to spikes in world oil prices. It's a tough balancing act to weigh efforts to head of recession versus keeping the lid on inflation. But we are facing the prospect of stagflation, something we haven't seen since the 70s.

"Men cannot escape being governed. Either they must govern themselves or they must submit to being governed by others."
- Theodore Roosevelt

Originally Posted by Iriemon Very good article, IMO. Of course, it's not fair to blame Bernanke for the mortgage loans situation; a product of lack of regulation and perhaps interest rates that were kept too low too long in the early 00s by his predecessor. And it's not his fault that the oil interests have prevented any meaningful energy policy, which left the nation unnecessarily vulnerable to spikes in world oil prices. It's a tough balancing act to weigh efforts to head of recession versus keeping the lid on inflation. But we are facing the prospect of stagflation, something we haven't seen since the 70s.

Originally Posted by Goldenboy219 Of course its fair to blame Bernanke, as was stated by Galen, he played politico by downplaying concerns publicly amidst a period of cost push inflation coupled with a housing bubble that inevitably popped. Instead of addressing these concerns in a responsible manner, and calling it like it is, he played the game and now is getting burned as a direct result of it. This only works if what your being told and warned about is dead wrong or off beat. Yet the federal reserve was created with very loose oversight from Congress, as well as a non existent audit system for the FR. Did Bernanke create this mess? Of course not, but this is how it goes. You become the head of a powerful institution given nearly full economic authority, and if you dont help avoid a problem, or at least up front about it IN THE BEGINNING , your gonna get burned.

Originally Posted by Kelzie Given this article, the Fed's decision to pump $200 billion into the financial markets will increase inflation quite rapidly, right? Or do y'all think the money will have little effect on inflation?

Kelzie,

You ask an important question.

Yesterday's decision should be inflation-neutral, as it does not increase the money supply.

The Fed now has two temporary mechanisms at present to inject funds into the financial system (aside from its permanent mechanisms):

1) Term Auction Facility (TAF): The Fed makes a pool of cash available for 28-day loans. Banks bid to borrow that cash. The interest rate is set by the bidding. Banks offer collateral to the Fed.

The Fed "sterilizes" the transactions by selling some of its inventory of T-bills to raise the funds for TAF. In effect, the Fed takes money out of circulation and then provides it to the banks in the form of the 28-day loans. Hence, there is no change in the money supply and TAF is inflation-neutral.

2) Term Securities Lending Facility (TSLF): The Fed makes a pool of Treasury securities available for loan in return for financial institutions' collateral for 28-day loans. As the transaction is merely a swap of securities, it also has no impact on the money supply and it is inflation-neutral. The TSLF was the new mechanism that was created yesterday.

Originally Posted by Kelzie Given this article, the Fed's decision to pump $200 billion into the financial markets will increase inflation quite rapidly, right? Or do y'all think the money will have little effect on inflation?