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Briefly, in mid 2006, I had written that the Fed’s financial obligations ratios suggested that the federal deficit had gotten too small to sustain the kind of growth we’d been seeing, and that aggregate demand would moderate until the economy got weak enough to get the federal deficit to probably about 5% of GDP as had been the case in most previous cycles.

And, at the same time, rising crude prices due to monopoly pricing power would drive up CPI.

I had also thought the Fed would keep rates steady or increase them as inflation expectations rose, and that the higher interest rates would further drive up CPI and support incomes through the interest income channel as the non government sectors are large (equal to the size of the outstanding Treasury securities) net savers.

GDP growth did start declining and CPI did start climbing, as did inflation expectations. However I was wrong about the Fed’s reaction as they cut rates long before CPI peaked. Ironically they made the right move regarding inflation, but the rate cuts did remove interest income and contribute to the decline in aggregate demand. The Q2 08 fiscal package more than offset that, however, and real GDP remained positive for the first half of 08.

The end of the fiscal package coincided with the Great Mike Masters Inventory Liquidation which was larger than I had ever imagined, lasting to year end, and driving GDP to unheard of post war negative numbers, particularly in the housing sector.

By year end the rapid increase in unemployment and the decline in tax revenues combined to increase the federal deficit to over 5% of GDP, boosting the USD net financial equity of the monetary system and slowing the decline of personal income to the point of ending the inventory liquidation and reversing the decline in the rate GDP some time during Q1.

Q2 GDP is currently looking to be somewhere near flat and maybe positive, with housing slowly on the mend as well, and with inventories starting from extremely low levels.

My proposals for fiscal policy once the inventory liquidation was in progress were the payroll tax holiday, revenue sharing for the states, and funding a job for anyone willing and able to work that included health care. This would have eliminated the need for unemployment to rise and GDP to fall as the means of restoring the federal budget deficit to levels necessary to sustain output and employment.

All with the caveat that energy prices would resume their climb as soon as stability was restored if there was not a credible plan in place to immediately cut US domestic crude oil consumption.

The Obamaboom is now underway due to the ‘automatic stabilizers’ described above, and the additional fiscal adjustments are now kicking in as well. Unfortunately we got here that ugly way, via rising unemployment and falling taxable incomes- a real and tragic cost that is, sadly, water under the bridge.

And, unfortunately, our crude consumption has dropped only modestly and is already increasing as GDP stabilizes, even at current levels of unemployment. As a consequence, crude prices are headed north again, and will support headline and eventually core CPI through the cost structure, as cost push ‘inflation’ resumes after pausing for the inventory liquidation. While off of last year’s highs, food prices are now rising from levels that are about double those of a few years ago and crude prices nearly triple earlier levels.

The US fiscal expansion is also likely to drive imports, with rising crude prices increasing the US import bill as well.

This keeps a lid on domestic employment as unemployment remains high and real wages stagnate, meaning increases in real consumption and wealth due to productivity increases and (some) employment gains necessarily flow to the ‘top.’

It also means US dollars will be ‘easier to get’ overseas which puts downward pressure on the USD. The Fed and Administration is prone to look at this as a ‘good thing’ as they view increased ‘competitiveness’ that drive increased exports ‘necessary’ to ‘balance the trade account.’

For the real economy, rising prices of imports while nominal wages are contained decreases real standards of living as workers use up their take home pay on food and energy and export a greater share of their output rather than consume it. This is what happens with an administration that doesn’t understand that exports are real costs and imports real benefits.

The Fed will soon be looking at sub trend GDP, unacceptably high unemployment, a falling dollar, rising headline CPI and rising inflation expectations.

Recent history says they will keep rates low as long as they perceive an continuing output gap.

The administration will see the same data and be hesitant to blame the Fed for inflation, for fear of triggering higher interest rates.

Ironically, this disturbing scenario is currently a historically a near ideal environment for nominal equity prices, so the administration will also be seeing increasing wealth in the financial sectors, at the senior management level, and in the investor classes in general, while pondering what to do about unemployment in the face of rising inflation.

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