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Friday, May 23, 2008

Kansas City Fed Chief and I Agree

Accoirding to the Kansas City Fed Chief, the significant rate cuts the Fed has undertaken has created inflation and soon the Fed will need to raise interest rates.

Investors reaping the rewards of low interest rates should prepare themselves for a reversal of fortune.

The Fed’s moves to cut rates — now down to 2 percent in its latest action from 5.25 percent eight months ago — are over, and rate hikes to stop raging inflation could soon follow, predicts Kansas City Fed President Thomas Hoenig.

"Some would dismiss these rising inflationary pressures as temporary,” he said. "I believe they are more serious.”

The U.S. annualized inflation rate hit 4 percent in March. Energy prices rose by 17 percent, transportation by 8.2 percent and food by 4.5 percent.

A slowing U.S. economy, and potentially a slowing China as a result, could slow inflation naturally, presuming the price of oil falls, too. But the traditional solution is to put less money into the economy, and that means the Fed must raise rates

I have been saying since last year that I am troubled that the Fed action is so aggressive that it will soon lead to inflation.

Now, whether or not the Fed chief of Kansas City is right still remains to be seen, however if he is we will have history repeating itself only in reverse. At the end of 1999 Alan Greenspan began raising rates aggressively to avoid inflation. Of course, he raised rates so aggressively that it lead to a recession. After raising rates into 2000, he spent the next three years lowering rates back down.

If a Fed Chairman raises or lowers rates and then has to reverse themselves and start doing the opponsite just as furiously, then the policy is faulty to begin with.

Now, without calling Bernanke's policy faulty, that is exactly what the Fed Chief of Kansas City is proclaiming. If Bernanke soon reverses course and begins to raise rates just as aggressively as he lowered them, then he is tacitly admitting that his initial policy was a failure. You aren't supposed to cause a new economic problem by fixing another one, and yet that is exactly what Bernanke may have done. By fixating on the recession so obsessively, he totally ignored the potential for inflation that he was causing. Now, that policy maybe coming back to haunt us.

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