By Numerian

This is the battlefield on which corporations and their customers are struggling for survival. If companies can make price increases stick, the consumer is going to bear the burden of inflation, and for a lot of consumers this can be the last gasp to bankruptcy.

Image:  Anonomyous

The Federal Reserve is on the defensive over its next round of Quantitative Easing, known as QE2. Over 20 distinguished economists and market analysts placed an ad yesterday in The Wall Street Journal urging the Fed to drop its plan to purchase $600 billion in Treasury securities over the next six months. Finance ministers around the world have deplored this policy for its tendency to generate global inflation and scupper the dollar on the foreign exchange markets. Even that noted financial expert Sarah Palin has published a Facebook criticism of the Fed’s “running the printing presses.”

Some Federal Reserve governors have warned about the potential inflationary implications of QE2, even though they voted for it. Fed Chairman Ben Bernanke and NY Fed President William Dudley have been in the media during the past week, justifying their QE2 decision. If you analyze their comments carefully, you realize they haven’t been helping their cause.

Bernanke has said that QE2 cannot possibly be inflationary because it does not introduce any new money into the system. He described it as an “asset swap”, whereby the Fed buys Treasury securities in the 5 to 10 year maturity range from banks, and in turn increases their reserve balances at the Fed. This is technically true when you look at things from an accounting viewpoint: in any double entry bookkeeping system every credit has to have a debit. In this limited sense, a bank is merely exchanging financial assets.

This point of view, however, is either disingenuous or badly misinformed. Yes, the bank is exchanging assets, but the bank is receiving cash from the Fed, an asset which earns no interest and which will likely be dumped as quickly as possible by the bank for something with a better yield or the potential for capital gains. The Fed knows this; it has watched banks take cash from QE1 and funnel this cash immediately into the stock market, junk bonds, commodities, and precious metals.

Where does the Fed get the cash?

More important, where does the Fed get the cash that it credits to the bank’s account when the bank offers up Treasury securities? The Fed creates this cash out of thin air, as an electronic blip when it credits the bank accounts with reserves. Bernanke conveniently ignores this $600 billion of new cash in the system, because he doesn’t think the Fed is part of the system. This is peculiar reasoning, suggesting the Fed doesn’t even recognize its role as the new 800 pound gorilla in the bond market. The fact is that before QE2 the US Treasury was scheduled to sell over $1.2 trillion in securities this coming year to fund the federal deficit. The potential buyers included private investors around the world, as well as major creditor governments like China and Japan. Now – suddenly – there is a new buyer in the market for nearly half of the amount to be auctioned. With the Fed buying such a huge amount of the federal debt, the Treasury doesn’t have to worry so much whether the Chinese are going to reduce their purchases, and the banks which underwrite these auctions – the Primary Dealers – don’t have to worry that they are going to be stuck holding unwanted paper. It is ridiculous for Ben Bernanke to ignore the implications this has for market behavior.

William Dudley has created a whole new defense for QE2.

“People do not understand clearly” that “we can have an enlarged balance sheet and not have a long-term inflation problem,” Dudley said in an interview with CNBC. “We are very confident of our ability to exit when the time comes.” Bloomberg, Nov 16

Dudley argues that new authority from Congress that allows the Fed to pay interest on bank reserves gives them a tool that will prevent inflation from occurring as a result of Quantitative Easing. Leaving out the fact that this is an untried and untested monetary policy tool, and that the Fed already has the ability to raise or lower the Fed Funds rate (Fed Funds are reserves banks borrow and lend to each other), what comfort are we to take from the Fed’s assertion it can act in time to prevent inflation?

Real inflation - commodities

Evidently very little comfort, going by what is happening here and now in the market. In a report published today by Bloomberg, retailers like The Gap and JC Penney are facing “terrifying” price increases of 30% on purchases of cotton clothing from China. Futures markets in China have priced in increases of 70% for raw cotton and cotton/polyester blends. Cotton is only one commodity to have experienced an explosion in price: ever since the Fed announced QE2 in late August, price surges have occurred in wheat, corn, sugar, oats, gold, silver, palladium, rare earth metals – wherever fast money was put to work earning something more than 0% on bank reserves.

There is more to China’s inflation problem than hot money chasing fast returns. China’s labor markets have been under pressure due to a shortage of skilled labor, and growing resistance from its work force to low wages. China is also coping with a property bubble that is no longer controllable by the government, especially since its response so far has been modest and inadequate increases in interest rates. To this situation, the Fed is now pouring fuel on the fire with its QE2 program that will add $600 billion more of hot money to the global markets. No wonder China has come out in protest of this policy.

Notice something important here: asset inflation is already in the markets before the Fed has even begun its QE2 program. As with most everything to do with the markets, it is the expectation of government behavior that motivates decisions by investors. The Fed got the intended result of QE2 merely by announcing it was thinking about it, especially since Fed officials suggested they wanted to instigate inflation higher than the 2% target they have set for years. What is also ironic is that the Fed fully expected QE2 to push Treasury rates down by as much as 0.75%. Instead, rates for the 10 year maturity have been heading up, and there has been an explosion in rates for 20 and 30 year Treasury bonds, as investors are growing nervous about global inflation. If this pattern persists, QE2 will have the perverse consequence of higher interest rates, just as occurred under QE1.

Price inflation is starting to seep into the retail sector as a result of all the liquidity pushed into the system by central banks. The big question now is whether this is part of a real trend, or whether companies will have problems imposing price increases at the retail level. The answer has to do with the “stickiness” of price increases. With the economy as weak as it is, and with unemployment as high as it is, there are many sectors of the economy that cannot impose price increases without pushing customers away. The consumer can hold on to their old car one more year, cancel their annual vacation, and cut back on Christmas gifts. If your only option is to drive an automobile to work, however, you have to pay the going rate for a gallon of gasoline.

The battlefield

This is the battlefield on which corporations and their customers are struggling for survival. If companies can make price increases stick, the consumer is going to bear the burden of inflation, and for a lot of consumers this can be the last gasp to bankruptcy. If companies find significant resistance from consumers to price increases, so that sales fall precipitously, companies will have to absorb the price increases in their gross margins, which means that profits will fall. Companies which operate on thin margins, like most Chinese exporters, will be especially vulnerable, and many will not survive margin compression brought on by inflation.

No wonder the Chinese government is getting a bit panicky about QE2, and lecturing Barack Obama on the dangerous practices of the US government. Some economists have theorized that this is the purpose of Quantitative Easing – to get the Chinese to abandon their yuan peg to the dollar because the cost of imported inflation will become too high to bear. Maybe this is so, but the cost to the global economy from QE2 is becoming too high to bear considering the inflation in commodities that has been let loose. American consumers and companies are beginning to find out just how large this cost has become, which is why even in Congress there are calls to abolish the Fed, or change its mandate so that it can no longer bet trillions of dollars without any oversight or any discussion with elected representatives in Congress. The Federal Reserve is about to discover it bet not only the taxpayers money on QE2, but the independence if not the very existence of the Fed itself.

First published at The Agonist