The Inflation Knuckle Ball

03/29/2011 01:48 pm ET | Updated May 29, 2011

Inflation has now manifested itself in nearly every asset class and price level in our economy. Fed Chairman Ben Bernanke's plan from the start has been to lower the dollar's value and cause asset prices to rise -- especially in real estate. But that goal was full of hubris from the start because the Fed can't control the exact rate of inflation nor can it direct where inflation will be distributed across the economy. In other words, inflation is like a knuckle ball: once you let it loose, you're never really sure where it will end up. And Bernanke's pitches are so wild they would make Tim Wakefield jealous. But the Fed's printing spree is so far off the mark that Bernanke now has a difficult choice. He can either do nothing and allow most price levels in the economy to become intractable or to raise interest rates significantly and crush the housing market.

Data released last week shows that the median home price of existing homes declined 5.2% in February compared to the previous year, to $156,100. New home prices fared even worse; the median sales price dropped to $202,100 in February, from $221,900 a year earlier, a tumble of some 9%! And data released today from the S&P/Case-Shiller 20 city home price index showed that prices have now dropped 6 months in a row and were down 3.1% from last year.

Yet, perhaps nowhere is the Fed's inflation madness so apparent as in commodity prices. Gold is up over 4% in the last three months, as M2 is rising at a 6% annualized rate. The CRB Index is up 8% so far this year and the Dollar Index has lost 4% of its value over the same period. The dollar is down against other fiat currencies in the last three months despite the following: the world's third largest economy has most likely been taken off-line due to a catastrophic earthquake; the EU was placed further in turmoil when the Prime Minister of Portugal failed to pass his austerity measures and was forced to resign; and, a plethora of Middle Eastern countries have erupted in violence, leading the U.S. to enter into a war with Libya. Yes, in the face of a world of turmoil, still the dollar fell. This is clear evidence that Bernanke's policies are causing investors to second-guess the dollar's historic 'safe haven' status.

It's really no wonder that faith is waning. The effects of inflation are being felt right now and there is no prospect for a change in policy any time soon. By all reasonable accounts, commodity prices will continue to surge as real interest rates continue to fall. Right now, the yield on the one year T-bill is .23%, while the YOY increase in inflation is 2.1%. And this is using the government's twisted figures! I estimate real interest rates are somewhere close to -8.75% if using a more realistic inflation rate of 9%. Therefore, investors are being thrust into the arms of precious metals and away from dollar-based assets. There really isn't much choice.

However, since the real estate market was in a prolonged and lofty bubble, it will be the last asset class to respond to the Fed's dollar debasement strategy. Bernanke should have studied more about asset bubbles than the Great Depression. If he did, he would have learned that gold took decades to recover to its nominal high in 1981 and the NASDAQ is still 45% below its all-time nominal high set over a decade ago. And those markets were allowed to clear, unlike housing prices, which are being levitated by the government. But amazingly, since 40% of the core CPI is owner's equivalent rent, Bernanke will continue to miss the mark about the true level of the inflation he has created.

The aftershock of the real estate bubble has sent millions of homes into foreclosure, left 11% of homes vacant, and caused 23% of mortgage holders to be without any equity in the home. And since home prices are still falling the number of individuals with negative equity continues to increase. The housing market is still very anemic despite the fact that the government is providing 95% of new mortgage financing. But unless the Fed starts to create credit to buy houses directly off the market, it will be very difficult to get real estate values to move higher. If Bernanke does chose to go that route, I'd recommend taking the money you got from selling your house to the Fed and find a property in a country that actual cares about its currency.

It is clear that by trying to target his inflation into just one asset class, Bernanke has placed the entire US economy in severe danger. And he is now facing a serious conundrum. Does he raise interest rates significantly to fight inflation and thus pour a concrete containment structure over the housing market, or does he sit idly by and watch the broader economy suffer an inflationary meltdown? The fallout from either choice isn't pleasant. But we can be assured of this: if he waits for the bond vigilantes to raise interest rates for him, the situation will quickly spiral out of control.

Michael Pento is the Senior Economist for Euro Pacific Capital