Get Ready for Rising Prices

by David Dreman

The markets, the dollar and commodity prices have all plunged and then rebounded. Financials are still falling. Economic news both in the U.S. and abroad continues to get worse. How do you chart a course in all this? Through all the smoke, and the cacophony of distressed voices on the financial battlefield, I find several things you can sensibly do.

Before you do any of them, you need to recognize the dilemma that the Federal Reserve and the Administration find themselves in—and are powerless to resolve. As investors are painfully aware, banks, investment banking firms and Fannie Mae and Freddie Mac (which have almost become penny stocks) are still drowning in seemingly endless pools of bad mortgages. Despite ample borrowings from an indulgent Fed, banks are far less liquid than when the crisis began. As loan defaults continue, they’re going to have to write down their portfolios even more, further impairing their capital and shrinking their stock prices. They’re reaching a point where they can’t raise new funds without badly diluting current shareholders. Thus the input of new funds by the Fed hasn’t lowered rates for mortgages or raised the financial institutions’ liquidity.

Consumers are trapped by stagnant wages, depleted savings and falling house prices. They’re slipping behind on their mortgage and home loan payments, and their spending is being squeezed harder than in more than a generation. So the Fed and the Treasury have no choice but to keep interest rates low until the current liquidity problems are under control. Not to do so would result in a steep recession and the threat of a financial panic. Yet keeping rates down risks damage to the economy from the highest inflation since the 1978–81 period, when prices rose at an average of 11% a year. That’s the Fed’s dilemma.

The July Consumer Price Index was 5.6% higher than a year earlier, the Producer Price Index 9.8% higher. Import prices, thanks to a weak dollar and expensive oil, are 21.6% above a year ago, the largest one-year increase since the index began in 1982. Optimists predict that energy, raw material, commodity and import prices, the strongest forces behind rising inflation, are likely to reverse direction and drop significantly. Wishful thinking. The world is short of oil, and the appetite for it keeps growing at almost double the rate of new discoveries. There hasn’t been a year since 1984 when new finds outstripped consumption. Even if a recession slows down oil use in the U.S. and Europe, demand will still increase in China, India and the Middle East. Rapid industrialization in those regions will continue to drive up commodity prices.


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