FED´S REFLATION BET COULD HIT CONSUMERS BEFORE IT HELPS / THE WALL STREET JOURNAL ( VERY HIGHLY RECOMMENDED READING )

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OCTOBER 10, 2010, 1:42 P.M. ET.

Fed's Reflation Bet Could Hit Consumers Before It Helps

By KELLY EVANS

Fed huffs, stock market puffs. If only the story ended there.


Since Federal Reserve Chairman Ben Bernanke hinted at a whatever-it-takes approach to keeping the U.S. economy afloat in late August, the market has behaved almost exactly according to plan. The S&P 500 is up about 11%. The yield on the benchmark 10-year Treasury note, which sets borrowing rates for things like mortgages, has sunk to 2.382%.


That is precisely how the Fed is hoping to reflate the U.S. economy. Make mortgages cheaper, and demand will help keep home prices from dropping. Get a rally going in stocks, and the accompanying "wealth effect" will lift consumer spending. Push down interest rates on cash, and people and companies will be less inclined to save and more likely to spend or invest.


It sounds almost too good to be true. Sadly, it probably is. Policy makers can unleash a flood of liquidity into the U.S. economy, but they have little control over where it washes up. And lately there are some troubling signs that the Fed's pursuit of inflation risks leaving the U.S. with something like stagflation instead.


Consider some of the standout performers since late August. Investors may be warming to U.S. stocks, but commodities are on fire. Gold is up about 10%. Oil and copper are up some 16% each. Silver is up nearly 30%. Soft commodities like corn, wheat, soybeans, butter and sugar have added to their rallies, too.


But U.S. consumers are hardly positioned right now to absorb higher prices. Rather than sparking "good" inflation, caused by strong demand and reduced slack in the economy, "bad" inflation that behaves more like a tax could result. A 15% rise in gasoline prices above August levels would, in theory, require households to spend an extra $48 billion annually, or $430 each, for the same amount of fuel, according to Capital Economics. A 5% increase in food prices, meanwhile, would slice another $40 billion, or $360 per household, leaving less room for discretionary purchases.


The burden also tends to fall disproportionately on lower-income households. Ken Matheny of Macroeconomic Advisers calculates that the 6% jump in gas prices so far since the end of August could shave nearly half a percentage point off fourth-quarter consumer-spending growth. The "wealth effect" from the stock market's rebound could offset it in aggregate. But who benefits? Middle- and upper-income households.


Fed policy makers may be striving to kick-start growth and reduce chronic unemployment levels. But because assets like commodities are responding to cheap money much faster than, say, houses, the Fed risks drowning struggling U.S. consumers instead.


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