Inflation is not caused by declining interest rates

April 29, 2008

Many on the street have accepted a common misconception that threatens to ruin your portfolio. They want you to believe a temporary end to Fed rate cuts will somehow indicate a shift to hawkishness with regards to inflation. That’s total nonsense. Interest rates do not need to be in continual decline to influence inflation, simply maintaining interest rates at a low level will do the trick. Inflation is not caused by the slope of rate changes, it is literally the new money pumped into the system.

New money can enter the system in many ways, fixing rates at low levels to influence individuals and businesses to take new loans is just a single example. Bailing out insolvent banks by exchanging real dollars for monopoly money (a.k.a. subprime mortgages) can also be inflationary.

However, until those new dollars begin to circulate throughout the economy that inflation will not show up in prices, which means, contrary to everything you believe, once the banks are finally re-capitalized and resume their lending scheme (however long that takes) only then will we see the inflation many fear. You haven’t seen anything yet. Rescued banks will not cause the non-existent commodities “bubble” to collapse — in fact the exact opposite is more likely — they will cause prices to increase even faster.

There are only two solutions to this problem, one is more economic growth and the other is less consumption. Printing money will not help either. We are entering a new era in global finance, rooting for the financial sector is like rooting for cancer. Ordinary people should take shelter with real assets outside their domain and hope many banks disappear.