Friday, April 28, 2006

The Octopus Prognosticates

It's not a good idea to blog about economic topics after too much sangria, but that is what our sea creature heart moves us to do so that's what we do. Why is inflation bad? I've wondered many times. I paid $47 to fill the tank of my Dodge Intrepid this morning. I stared at the price, fucking shocked. Sticker fucking shock. But what the hell am I going to do? Hope that China continues to raise its interest rates, slowing its demand and thus lowering gas prices? Maybe I should take the bus. I should take the bus. But I like that extra hour of sleep.

Anyway. If gas prices go up, as they certainly will (oh yeah, let's roll on into Iran!), prices for everything that needs to be delivered by anything powered by gasoline, oh, let's say everything will go up. Okay, so what? We should eventually get paid more as well, right? Okay. But because inflation goes up, the value of the money paid back to a lendor diminishes, so to compensate they must charge a higher interest rate. Fine, that makes sense. But as the interest rate goes up, even though to find the real interest rate one should subtract from the nominal interest rate the rate of inflation, people will react to the higher interest by cutting back on investment and home purchases. A major factor in current economic recovery has been the rising value of home prices; people have used the increased equity for disposable cash. With higher interest rates the demand for homes will go down, bringing down the prices of homes, cutting into that equity that makes people feel flush, cutting consumer spending. (However, the fall will not be as dramatic as some have feared, it appears, because the economy has diversified a bit.)

Perhaps new Fed Chief Bernanke sees which way the wind is blowing and for that reason has preemptively hinted that the Fed is through with its recent run of raising interest rates. With the coming inflation, interest rates will be sent up anyway. Might as well let it ride for the moment. No need to raise rates that will be lifted by forces outside of our control.

The magic of economics. As interest rates rise because of inflation (the falling buying power of the dollar), presumably, the deposit interest rate should rise, thereby attracting foreign capital to U.S. bank accounts and investments that offer a comparatively high interest rate. As people buy U.S. dollars to invest or deposit in U.S. accounts, the value of the dollar begins to rise again, decreasing inflation, deflating the interest rate.

Back and forth, up and down. But anyway, that’s the theoretical long-run. In the short run, interest rates seem sure to rise, and at some point, people will react by pulling back in investments, and companies are no longer able to borrow the money they need to expand. Hello contraction. With a contraction of course, you get a dramatic reduction in demand, and a resulting deflation, lowering the interest rate, theoretically prompting renewed investment and expansion.

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