, , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , , ,

Unemployment and inflation are to some extent political decisions.  The President, Congress, and the Federal Reserve all can move one figure one way, by moving the other figure in the opposite direction, but it’s rarely an equal trade-off.   The President and Congress can do this with deficit spending, while the Federal Reserve can ignore inflationary signs and keep loose monetary policy so as to try to lower unemployment.

Rarely, however, does trying to manipulate these figures in dramatic ways result in much good.  We opted for inflation twice in the 1970’s and even though unemployment initially fell, it was still well above the average.  Indeed, at one point, prices became so unstable that unemployment started to rise alongside inflation, showcasing that even a political decision to lower unemployment by driving up inflation, can often result in the latter without the former.

Our current environment is similar to the 1970’s in many ways.  The Obama Administration made a political decision to lower unemployment by driving up inflation in 2009 with the stimulus package.  Instead, we ended up with higher inflation and higher unemployment.

While I believe many have misunderstood the Federal Reserve’s actions over the past few years and that the first round of quantitative easing was the right decision, I do think they’ve drifted towards a more dangerous path over the past six months.  “QE3” as it is called seems to be an open-ended mandate to ignore inflation in order to improve unemployment.  Unlike the President’s stimulus package, at least the Federal Reserve’s actions over the past year or two have likely resulted in lower unemployment, but I think it will come at an increasingly heavier cost in terms of inflation than people believe.  Inside the Fed bubble, it’s almost as if they don’t believe inflation is possible at this point, in spite of some troubling signs in M2 money supply growth.

Indeed, inflation is still subdued, but there are a lot of odd things going on with the data.  For one, inflation is subdued largely as a result of things happening in China, not the US.  The collapsing of China’s real estate bubble is helping driving down oil and commodity prices in the US. Meanwhile, rental prices have been growing more rapidly than might be expected in this environment.  And now, housing prices seem to be increasingly rapidly, as well.  While the trend only started a few months ago and it may be a bit early, I’d still worry about it a bit with other signs.

So where are we going?  I’m not sure.  I wouldn’t be surprised to see unemployment continue to creep down, but I think you’ll see inflation (and housing prices, in particular) start to come up as that happens, and the overall trade-off may not be ideal.   Which is why I think we may be in for a repeat of the stagflationary 1970’s.

On the other hand, as I’ve detailed in some of my previous articles, I believe that the US economy was being held back by currency manipulation in China, and that China’s currency export subsidy will be destroyed in the upcoming years, thereby allowing US exports to normalize a bit.  The other positive development comes in the energy sector, where we’ve seen major advances in the past decade, which have resulted in significantly lower prices.  This could help fuel more economic growth.  Given these positive developments, there are some reasons to be optimistic, but even with that, expect more subdued growth than normal.