Trapped: The Fed Has Painted Itself Into a Corner

As prices for commodities such as cotton, sugar and grains skyrocket, many financial commentators have been pointing the finger at Federal Reserve Chairman Ben Bernanke's "easy money" policies of zero interest rates (ZIRP) and quantitative easing (QE2) as a major cause.

The Fed intended these two policies to lower long-term interest rates and to nudge investors into riskier assets, thus stimulating growth. At least one part of that strategy is working. By lowering the yields on traditional financial investments such as bonds to near-zero, the Fed has essentially forced trading desks and hedge funds to scour the globe for higher yields.

Many traders and investors have found that higher yield in commodities, which is where speculative money is now flowing in abundance, helping to push up prices. Because the price of wheat, for example, is roughly the same everywhere in a global market, these rapid price increases are destabilizing poorer countries where much of household income is devoted to food.

Charges and Countercharges

Global demand for many commodities is outstripping supply, and that imbalance is a key factor in higher prices around the world. But a global economy awash in low-interest, speculative "hot money" seeking higher yields is further fueling imbalances.

Fed officials have faced pointed criticism from nations such as China and Germany, which see the Fed's policies as firing up inflation and suppressing the U.S. dollar. Fed Chairman Bernanke has countered these charges by identifying the problem as one of currency valuations. He suggests that other nations should offset rising commodity prices by letting their currencies climb in value.

Bernanke's protests, however, have a hollow ring: Clearly, skyrocketing commodity prices aren't just a currency-trade issue. For example, consider this cotton-price chart, which has "gone parabolic." Can anyone seriously claim that the "solution" to this situation is for China to allow its currency, the yuan, to appreciate? Is the yuan the real cause of wheat and corn both shooting up 80% in 2010?

The reason why Bernanke's claim is so transparently nonsensical is that commodities are rising everywhere, not just those originating in China. Despite official assurances that inflation in the U.S. is now running at a modest 0.7% annually, by one measure, it's actually hitting an annual rate of 2.5%. By another, it's already a white-hot 10.6%.

This chart shows how rising prices are built into the supply chain, with the result being costs of intermediate and crude goods are rising smartly.

Inflation is running hot around the world, not just in China and the U.S. This also suggests that the issue isn't one that can be resolved with currency adjustments.

Even though inflation appears to be lower in the U.S. than in other major economies, it's hitting the average U.S. household hard because wages aren't rising along with prices. Indeed, according to the U.S. Census Bureau, real median household income in 2009 was $49,777, a 5% decline from the 1999 peak of $52,388 (adjusted for inflation).

This is in marked contrast to nations such as China, where workers are gaining substantial raises (21% in Beijing, for example), to counter rapidly rising costs.

An Unbreakable Cycle

The Fed is being disingenuous in claiming it's blameless for global inflation. And in a larger sense, the central bank is attempting to repeal the business cycle. In the normal course of capitalism, low rates and easy credit lead to increased borrowing, which leads to rising consumption and investment in production to feed that increased consumption.

This leads to higher profits, which generates more investment and credit expansion.

At some point, the cycle hits a brick wall: Borrowers can no afford to pay more interest as rates rise, so debt stops increasing, and consumption and demand slump as borrowing levels off. In the rush to mint profits, production capacity now exceeds demand. And as a result, prices and profits both fall -- the natural consequence of excess capacity.

As the boom progressed, investors sought out riskier, more marginal investments. But as new debt and demand fall, these riskier investments lose money and are either shuttered or sold for a loss.

Then, as profits decline, workers are laid off, and commercial borrowers find their income streams aren't sufficient to meet their obligations. The credit cycle turns from expansion to contraction, as marginal borrowers go bankrupt and insolvent businesses and loans are liquidated or written down.

This purging of bad debt, speculative excess and misallocated resources lays the foundation for another cycle of renewed growth.

Credit Goes to the Wrong Hands

But the Fed is attempting to repeal this business/credit cycle. Rather than allow credit to fall sharply and interest rates to rise as bad debt is purged from the financial system, the Fed has pursued a policy of making credit even cheaper in the hopes that borrowers will be able to borrow more since rates are near-zero.

However, because consumers and enterprises are still burdened with mountains of existing debt and undeclared losses, few are willing or qualified to borrow more. As I recently wrote here, consumer debt in the U.S. has declined a paltry 2.7% in the wake of the Great Recession.

The Fed's quantitative easing thus ends up flowing not to households or productive enterprises but to the "too big to fail" banks and Wall Street firms, which then seek higher returns in assets such as stocks and commodities. The Fed's intention was to push money into productive growth, but instead it has fed pools of speculative money chasing high returns in global commodities. This is helping to fuel inflation in food and other commodities -- not just in the U.S. but globally.

In a Double Bind

Now the Fed has painted itself into a corner. If it keeps interest rates low and continues pouring hundreds of billions of dollars into "hot money" hands, it will be adding to the destabilizing forces of rising commodity inflation. If it stops its QE2 stimulus to help cool global inflation, then interest rates will rise, pushing marginal borrowers out of the market and increasing borrowing costs for everyone from new home buyers to Wall Street speculators. That could destabilize the fragile recovery and the bull market in stocks.

By attempting to repeal the business cycle and refusing to allow a necessary credit cleansing (writing off of bad debt) and repricing of risk, the Fed has created an inescapable double bind for itself: either continue pursuing easy-money policies and help destabilize the global economy with rising commodity inflation, or allow interest rates to rise and destabilize speculative markets and marginal borrowers.

View all Articles » Charles Hugh Smith has been an independent journalist for 22 years. His weblog, www.oftwominds.com, draws two million visits a year with unique analyses of global finance, stocks and political economy. He has written six novels and Weblogs & New Media: Marketing in Crisis and just released Survival+: Structuring Prosperity for Yourself and the Nation.

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How Hyundai Turned a Corner in the U.S.

Last year was hardly a banner year for auto sales in the U.S. In fact, with a mere 11.6 million vehicles sold, it was one of the worst in recent memory. Still, depressed demand didn't stop a few car companies, including Hyundai and Kia, from setting sales records.

Hyundai's U.S. sales rose 24%, to nearly 540,000 units last year, a new record that helped the automaker claim 4.6% of the American market, its highest share yet. Kia set its own milestone, selling nearly 357,000 cars and utility vehicles, a 19% increase compared to a year earlier.

The fortunes of the two companies, which share a corporate headquarters in Seoul, South Korea, but market their products separately in the U.S., have been buoyed by their ability to build well-designed, affordable and fuel-efficient vehicles that consumers want to buy. (Hyundai Motor owns about 39% of Kia Motors. Together they form the world's fifth-largest automaker.)

A Successful Sonata

One example is Hyundai's Sonata midsize sedan (pictured). Redesigned for the 2011 model year, the Sonata largely received glowing praise from the automotive press for its sweeping styling -- Hyundai calls the design "fluidic sculpture" -- high-quality materials and construction, and good driving dynamics.

Those qualities have also helped make the Sonata a hit with consumers, too. The 2011 Sonata, which debuted in early 2010, sold nearly 200,000 copies in the U.S. last year, a 64% improvement over prior-year sales of the previous model.

On the heels of the successful Sonata, Hyundai has introduced revamped versions of the Tucson small SUV and Elantra compact sedan, which also feature the company's now-signature swooping design. Soon to follow is a refashioned Accent subcompact, which will make its North American debut at the New York International Auto Show in April.

These vehicles are very competitive within their segments, says David Sullivan, an analyst with AutoPacific, an automotive research firm. "Hyundais are no longer vehicles that you should be embarrassed to own or want to aspire to own," he says, referring to earlier Hyundai models that offered U.S. consumers little more than a low sticker price.

Setting Design Trends Rather Than Following Them

Previously relegated to rental-car fleets, Hyundais have been transformed, offering pleasing interiors and sophisticated engines that are as good as anything Japan or Germany can churn out, Sullivan says. Much has changed from the days when Hyundais were a source of jokes for Detroit's auto elite, he says. "Hyundai is looking at many of them in the rear-view mirror right now."

The company credits its sales momentum in the U.S. to its focus on two key strategies: design and fuel economy -- 86% of the vehicles Hyundai sells in the U.S. are equipped with four-cylinder engines. It's a recipe that no other carmaker has managed to pull together in quite the way Hyundai has, says John Krafcik, president and CEO of Hyundai Motor America, the company's U.S. subsidiary, based in greater Los Angeles. "I think that explains a lot of our success."

The initiative began about six years ago, when Hyundai Motor Chairman Chung Mong-koo challenged Hyundai's product-development team to lead the industry in design, rather than follow trends set by other automakers. The first product to emerge from that mandate was the Genesis coupe, which began U.S. sales in mid-2009, receiving mainly enthusiastic reviews.

The design concept, for the first time, gave Hyundai its own look and feel, says Krafcik, a veteran of the U.S. auto industry. Previously, Hyundai models were perceived as little more than knock-offs of cars manufactured by Asian competitors Toyota Motor (TM), Honda Motor (HMC) or Nissan Motors (NSANY). "We don't hear that anymore with our new designs," he says.

Demand for Elantra Far Exceeds Supply

Still, Krafcik says, unique designs don't always equal sales success. Two recent American-made examples of novel concepts that didn't meet with auto buyer approval were the 1996 Ford Taurus, which incorporated Ford Motor's (F) signature oval logo into everything from the dashboard to the rear window, and the 2001 Pontiac Aztek, one of several unappealing designs from General Motors (GM) that industry icon Bob Lutz compared at the time to "angry kitchen appliances."

The Genesis, 2011 Sonata and Elantra are all products of Hyundai's design studio in Southern California, which it shares with Kia. The Tucson, which features the same "fluidic sculpture" styling theme, was created in the company's European design studio in Germany.

As with the Sonata, the redesigned Elantra, which hit U.S. dealerships late last year, has seen demand increase significantly. Sales were up 25% in January to nearly 9,700 units. Krafcik says Elantra sales could surpass the 200,000-unit sales record set by the Sonata if they could manufacture enough of them, but he admits the company doesn't "have anywhere near the capacity for that level of volume."

Hyundai's sole U.S. plant, in Montgomery, Ala., recently increased capacity to 330,000 cars annually. After subtracting Sonata and models destined for export markets, such as Canada, that leaves manufacturing capacity for only about 70,000 Elantras.

The company believes it can easily sell more than twice that number, Krafcik says, so it will begin supplementing U.S. made vehicles with production from Hyundai's plant in Ulsan, South Korea. With capacity to produce 1.6 million vehicles a year, it is the world's largest automotive plant.

Plans call for the company to build 400,000 cars in the U.S. this year, including the Hyundai Santa Fe SUV, production of which was shifted to Kia's West Point, Ga., plant last fall, and sell slightly less than 600,000 cars in total in the U.S.

Hyundai Loses Ground on its Home Turf

Krafcik says Hyundai has no further plans to expand production in the U.S., citing the extraordinary costs involved in building new plants -- on the order of billions of dollars. "But we'll certainly look at how we do this year, see where the demand is [and] see where the demand is going."

Asian automakers, generally, are under increased pressure to manufacture cars and trucks in the foreign markets where they sell them as a hedge against foreign-exchange volatility that can pinch profits. The strong yen, for example, has led Toyota Motor President Akio Toyoda to suggest that his company may move some production out of Japan.

While Hyundai has enjoyed sales success in the U.S. and other markets, its fortunes on its home turf in South Korea have come under threat from imports, including BMW, Volkswagen (VLKAY) and Toyota. Hyundai saw its domestic market share slip 5 percentage points last year to a decade-low of 45% even as the South Korean auto market expanded 5%, according to Reuters.

Less Respect at Home

It won't be easy for Hyundai to gain back lost market share as imported cars continue to flood into the market and sister make Kia Motors continues to gain ground, Dongbu Securities analyst Yim Eun-young told the news agency.

In an interview, the company acknowledged it faces an uphill battle. "Our strong growth is well-received overseas, but we didn't get that proper recognition from Korean consumers," Sean Kim, senior vice president and head of Hyundai's Domestic Marketing Group, told Reuters. "Our priority is regaining trust and pride from consumers by doing everything from promotion, marketing and better product offering."

The home office might want to take some cues from its U.S. subsidiary, which seems to be firing on all cylinders.

View all Articles » David Schepp has covered business news for more than a decade at news organizations such as Dow Jones, BBC News and Gannett. His beats have included technology, biotechnology, health care and workplace. He lives in New York's Hudson Valley.

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