The new financial system bailout plan is causing inflation to rear its ugly head once again. Treasury Secretary Timothy Geithner announced last week an outline of the Obama administration's financial-sector rescue plan. To date, the financial markets haven’t liked it.
Year to date, both the stock and bond markets are off substantially as there looks to be nothing favorable in the these new plans for the banking system. The Dow Jones Industrial Average on Tuesday was down 16 percent for the year, led by financial sector stocks in the index.
The 10-year U.S. Treasury note is has also sold off dramatically so far this year, raising its yield from 2.2 to higher than 2.8 percent in recent days. The higher expected inflation rate evident in this higher interest rate is supported by a 7 percent year-to-date increase in the price of gold. Many commodities remain low, like oil, but gold doesn’t serve the same consumption purposes. Gold is primarily just a hedge against inflation.
There are conflicting views of just how bad a credit freeze we are under. In testimony, Geithner said we are facing an "enormously complicated financial system" and that the loan market is “not functioning”. In contrast, CEOs of major banks reported to Congress last Wednesday that their lending is actually rising.
The CEOs may rightly contend today that the financial markets are improving. Major U.S. corporations like GE and Cisco issued large of amounts of new bonds these past few weeks. The increased market participation in lending to large corporations is likely to lead an easing of credit conditions in all markets.
The government is moving forward nonetheless with plans to further support banks with hope for more business and consumer lending. Writing for The New York Times, Edmund Andrews and Stephen LaBaton report that the president’s current plan will lead to a far greater government role in markets and banks than at any time since the 1930s.
The cost of these plans will be higher inflation. Continued increases in government debt for direct equity investments in banks, or lending to private-sector firms for purchases of troubled assets on bank balance sheets, will most likely be funded down the road by further increases in the money supply. The primary determinant of a nation’s inflation rate is the extent to which the government prints money.
The U.S. inflation rate is monitored in one of two ways. The most widely discussed measure is the consumer price index, or CPI. The CPI shows the cost of a basket of goods and services relative to the cost of the same basket in some base year. The U.S. Bureau of Labor Statistics tries to keep track of the goods and services a normal U.S. household regularly purchases. The index is then calculated by holding this “basket” constant and determining the price changes. The percentage change in the index thus measures the inflation rate.
An alternative index is the Gross Domestic Product deflator. Like the CPI, the GDP Deflator also measures the overall level of prices in the economy, and these two price indexes usually move together. But there is an important difference evident now.
The CPI uses a fixed basket of goods for the typical consumer, while the GDP Deflator automatically changes the goods and services, based on what was actually bought and sold that year. This difference can lead at times to large gaps when measuring inflation.
The most recent CPI reading suggests prices may actual be falling. The CPI decreased 1.0 percent in December and was up only 0.1 percent of all of 2008. Meanwhile the most recent reading for all goods and services in the GDP Deflator rose by 1.8 percent during 2008. Prices for the basket may not be rising, but prices overall are definitely rising.
Policymakers may believe there is no risk of inflation at this time. The bond market, gold market, and alternative measures of price inflation suggest differently. An “inflation tax” is a real risk of continued plans for bailing out the U.S. financial system.
Since 2000, Peter R. Crabb has been a professor of finance and economics at Northwest Nazarene University in Nampa. He earned his doctorate in international and financial economics from the University of Oregon