Monday, October 24, 2005


New Fed Chair, thoughts about inflation

As many of you might be aware, the new U.S. Federal Reserve Chair was named today. Right before the announcement was made by President Bush in a news conference, I heard the following quote on CNN.

Kyra Phillips: "One thing has never changed. Greenspan's trademark ability to tell us anything we want to know in ways we cannot possibly understand."

I nearly fell out of my chair laughing. Her delivery was really quite perfect. Mildly sarcastic, yet believably earnest, in a way that Americans have perfected over the past 200 years or so.

So the new FED chief has been on record saying things that incline some of us out here in economics geekland to believe that he's much less hardcore about controlling inflation than Greenspan is. This is very significant, since inflation is the greatest enemy of the investor.

About the only "investment" that can "make" money in an inflationary cycle is being mortgaged to the hilt. However, this requires a priori knowledge (seeing into the future).

The reason mortgaging everything works in inflation (with fixed rate mortgages, that is) is because, for example, you take out a 100,000 dollar mortgage. You sit there with inflation rates climbing, and essentiall inflation largely pays off your mortgage for you, as prices rise quickly. You may end up paying the equivalent of a lot less "real" money at the end of the 15 or 30 years of the note.

If you rented, though, your rents would track inflation. If you owned your property outright, you are in a bunker, so to speak, but you paid up front in expensive (at the time) dollars.

Owning a home outright insulates you from pretty much everything except property tax. Renting leaves you owing whatever market or inflation sets the prices at, but you would assume that wages would at least try to keep up with inflation. This assumption isn't always true, though, as many of us either remember or can empathize with.

The problem with taking out loans to fight inflation is that the spread between the interest rate and the inflation rate is not in the borrower's favor. In other words, inflation has to go up, a lot, for the loan to be devalued over time, with respect to paying as you go. As inflation rises, interest rates almost immediately adjust, so you really have to get your loan well before inflation hits. This means you have to be able to either tell the future, or you know things that bankers don't.

So, what do we know that bankers don't?

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