Today’s big headline concerns Fed chief Ben Bernanke. According the Financial Times , he broke with long standing tradition in order to express himself on the dollar yesterday. Alas, the fall of the greenback has “contributed to the unwelcome rise in import prices and consumer-price inflation,” he said to an international banker’s forum.

The headman at the Fed may want a stronger dollar...or a weaker one; it’s usually not his place to say so. That’s what the Treasury Secretary is for. Henry Paulson, of course, says the same thing; the United States wants a strong dollar. But nobody believes him. Investors seemed to take Mr. Bernanke more seriously

Stock market investors sold shares and drove the Dow down 101 points. Over in the oil market, the black goo sank $3.45. And gold, too, was sold on the news...it sank $11 to $885.

But let’s think about this. What could the Fed do to protect the dollar? Easy...it could raise interest rates. But if the Fed wanted to protect the dollar, why has it waited so long? The greenback has lost about half its value since 2000, why didn’t it try to protect it sooner?

In the 15-year period known as the “Great Moderation” central banks could increase their supplies of money 2, 3, 5 times as fast as GDP growth. Normally, this would cause inflation. But it didn’t, because globalized markets...along with a few other key trends...we’re holding consumer prices down. So, the inflationary money went into asset bubbles...dotcoms, houses, and the financial industry.

After the housing/finance bubble popped last year, consumer prices rose – even while the world economy softened. All of a sudden, the world seemed to be spinning in the wrong direction. Instead of holding down prices in the United States and Europe, China was increasing them. China’s domestic inflation is running at more than 8%. And she’s exporting her inflation to the rest of the world. Import prices from China into the United States are now rising at 4% per year...after falling about 1% each year during most of the 21st century. As for imports from the rest of Asia, they were falling in price as recently as the first half of ’07. Now, they’re going up by 4.3% per year.

And even as demand for basic commodities slows in the developed world, demand from the emerging markets makes them more expensive. Ai yi yi...globalization is no longer a force for good...but a force for evil! Now, earnings and housing prices fall in the United States, for example – while Americans are forced to compete with Asians for food, fuel and jobs too.

House prices in America are still falling. Foreclosures continue to rise – especially in places such as Las Vegas, which has the distinction of being the “mortgage fraud capital of the world.” And now comes word that people are not only abandoning their houses – but their pets too. Yes, the Society for the Prevention of Cruelty to Animals says that owners are leaving their dogs and cats behind. And pet food banks, operated by the SPCA, are said to have people lined up down the block to get free food for their pets.

Meanwhile, Winnebago says it has had to put its Iowa plant in neutral. The company makes luxury land barges, which have been a big hit with Americans for many years, allowing retirees to take to the open road whenever the mood strikes them. Problem is, motor homes are expensive to buy...and now, with gasoline over $4 a gallon, extremely expensive to operate. In real terms, gasoline is higher than it has ever been in the United States...considerably higher than the $3 it hit (in today’s money) in 1981.

The feds’ response – so far – has been to cut rates, bail out financial firms, and hand out money (rebate checks). This inflation (along with robust demand from the emerging markets) has made itself felt, mainly, where the feds didn’t want it – in oil, gold and commodity prices.

…………&hel...

Ben’s nightmare to DR: “Gosh DR., I’m in a bit of a jamb. I’ve got rising consumer prices on the one side...and a falling housing market on the other. I should raise rates to head off inflation, on the one hand, but if I do that, I risk sending the economy into a recession. Then, I’ll get blamed for everything. The Republicans will lose the White House – and blame me, of course. The economy will sink – just like Japan in the ’90s – and I’ll get blamed for that too. It isn’t fair..

Wait...it’s actually worse that I made it sound. Because either way I go, I’m screwed. If I cut rates, the dollar will go down and the “crude oil cowboys” are going to push the price up to $200 – and the whole world economy could go into some kind of crisis. If I raise rates, on the other hand, I’m almost certainly dooming all those marginal homeowners to bankruptcy. They all live on credit. And if the cost of credit goes up...they’re going to be squeezed hard. What’s really happening is that we’re on the downside of the credit cycle. So the cost of credit is going up...no matter what I do.

And don’t even think about mentioning Paul Volcker. I’m sick of hearing his name. Let’s face it, he wasn’t a genius; he was just lucky to be on the right side of the credit cycle. Lending rates peaked out early in his term at the Fed...he could coast the rest of the way. I’ve got the opposite situation. Lending rates are bottoming out...just as I get started. It’s going to be uphill from here on...and I’m left holding the bag.

Did you see what happened in the bond market recently? The 10-year note yield went over 4%...and it didn’t come back down until speculators started to bet on a rate increase.

What can I do? Sit tight? But if I do nothing...and sit pat...I’ll get even more criticism. People will forgive you if you do the wrong thing; but they’ll never forgive you for doing nothing. Doing nothing is not an option.I just want to know what lever to pull on. The one marked ‘fight inflation’ or the one marked ‘fight recession’?”

Ben: “What do you mean? There are only two levers. I just wan to know which one to pull.”

Ben: “What do you mean by that?”

Ben: “Yeah...so what do I do?”

DR : “Well...you’ve got to think about it in a whole different way. People made mistakes. They built too many houses. They paid too much for those CDOs and MBSs and all the rest of it. They bought businesses for more than they were worth. You can’t do anything about those bad mistakes...except help people correct them as soon as possible.

You’re not doing any favors by offering more credit to a guy who is too deep in debt. And you’re not doing anything good for an economy that is living on borrowed time and borrowed money. What the whole system really needs is a correction. Why not give it one? Raise rates – a lot. That’ll send a message. Give people a reason to save again. And give the speculators a good spanking. Liquidate housing. Liquidate the banks. Liquidate the farmers. Liquidate the stock market. Liquidate the consumer. Liquidate the whole damned bunch. And while you’re at it, go on TV and tell the public the truth; that modern central banking is as fraudulent as Freudianism...and that from now on, you won’t be putting out any more funny money.

Ben: “Hold on...you know I can’t do that...

…………&hel...

Most commentators are of the view that the presently observed sharp increases in the price of oil are on account of supply problems. Existing oil fields are becoming depleted as time goes by while not enough new oil fields are being discovered. Some other commentators blame the supply issue on US government restrictions on extracting oil from various areas in the United States for environmental reasons. Without diminishing the importance of the supply factors, we suggest that another factor that must be considered is the contribution of the U.S. central bank’s policies to the recent sharp increases in the price of oil.

What makes it possible to generate the goods and services that people require to support their lives and well being is the capital infrastructure of the economy and not spending by consumers as popular economics suggests. It is the enhancement and the expansion of the infrastructure that permits an increase in the production of goods and services.

An improvement in the infrastructure makes economic growth possible. The key factor that enables the improvement of the infrastructure is the flow of real savings that funds the enhancement of the infrastructure, i.e., enables the production of various tools and machinery also called capital goods. (With better tools and machinery, a better quality and a greater quantity of goods and services can be now produced.)

The increase in money supply, which supports various new projects, sets the foundation for additional demand for various commodities, including oil. More money is channeled toward commodities and oil. Since the price of a good is the amount of money paid per unit of the good, this means that the prices of commodities and oil are now going up.

Once the central bank tightens its monetary stance, the diminished flow of money weakens the expansion in the bubble activities – an economic bust is emerging.

Once the money rate of growth slows down, this slows the diversion of real wealth, i.e., slows down the support for nonproductive activities. As a result, the demand for various goods and services that emerged on the back of nonproductive activities comes under downward pressure. Consequently, the prices of these goods, such as various commodities and oil, follow suit.

Following this line of thinking, we can suggest that there is a high likelihood that the massive increase in the price of oil that we are currently observing is the manifestation of a severe misallocation of resources – a large increase in nonproductive activities. It is these activities that have laid the foundation for the oil-market bubble, which has become manifest in the explosive increase in the price of oil.

The root of the problem here is the Fed’s very loose monetary policy between January 2001 and June 2004. The federal funds rate target was lowered from 6.5% to 1%, while the money rate of growth had risen strongly.

Obviously if the pool of real savings is shrinking – i.e., the flow of real savings is no longer sufficient to support various existing and new activities – economic growth will come to a halt and commodity prices will come under downward pressure, notwithstanding the Fed’s aggressive lowering of interest rates since September of last year.

Now, it is not only the Fed’s policies that must be blamed for sharp increases in the price of oil but also the policies of other countries such as China. Massive monetary pumping in China and the various structures that emerged on the back of monetary pumping there have contributed to the exaggerated increase in demand for various commodities, including oil.

For the time being, the pace of China’s nominal economic activity continues to push ahead. We have estimated that the yearly rate of growth of nominal economic activity stood at 38% in Q1 against 36% in the previous quarter. This, coupled with an upcoming effect of the loose Fed’s stance since September 2007, is likely to mitigate the downward pressure on the price of oil, all other things being equal.

We suggest that there is a high likelihood that the massive increase in the price of oil is the manifestation of a severe misallocation of resources. The loose monetary policy of the Fed from January 2001 to June 2004 is the likely key factor behind this misallocation. (The federal funds rate was lowered from 6% to 1%.) The tighter Fed stance from June 2004 to September 2007 should undermine the existence of various nonproductive activities and in turn reduce upward pressures on the price of oil.

Regrettably, the loose monetary stance that the Fed has adopted since September of last year, coupled with still very buoyant Chinese economic activity, is likely to counter any downward pressure on the price of oil. The Fed’s current policy of fighting an emerging economic slump is, in fact, a policy of deepening the misallocation of resources, thereby promoting higher prices for oil. If our thesis regarding the oil market bubble is valid, then it is the Fed’s policies that must be blamed for the erosion in consumers’ living standards and not the rising price of oil.