- - Sunday, February 16, 2014

ANALYSIS/OPINION:

The most important president in America may not be Barack Obama, who chases golfing dreams in drought-stricken California while we pause this holiday to honor giants like Washington, Jefferson, Lincoln, Roosevelt and Reagan.

The person whose spirit, spine and actions could affect each of us most is William C. Dudley, president of the Federal Reserve Bank of New York. If it becomes clear to Mr. Dudley that inflation is building across America, he and his colleagues at our central bank will have to increase interest rates, perhaps abruptly.

Why inflation matters in 2014

This week, we get report cards on inflation — the degree to which prices are rising for goods and services.

Held in check for years, inflation is not an abstract term for most Americans. Minuscule increases in the cost of food, health care, mortgage interest, gasoline, clothing and electricity have profound negative consequences.

In 2012 (the most recent year for which government estimates are available), the bottom 80 percent of U.S. households earned $39,636 after taxes and spent $39,443.

Because these Americans have a razor-thin cushion of savings and are constrained in covering shortfalls by borrowing, inflation makes for painful choices and high anxiety.

Failing to tame inflation poses dangers not only for Americans, because the U.S. dollar is the world’s reserve currency, used around the globe to store the vast amount of wealth.

If foreign investors believe we will not take steps to defend the value of our currency by lifting benchmark interest rates, the ensuing financial crisis will prove far more threatening than what happened beginning in September 2008.

A new world of rising interest rates

Since 2007, interest rates that professional investors in U.S. securities watch closely have fallen below recent historical average levels.

From 2008 through 2012, the average annual interest rate on 10-year U.S. government debt was 2.94 percent, compared to 4.71 percent from 2000 through 2007.

A second key interest rate is the one that large banks pay to attract overnight deposits — the “effective federal funds rate.”

Even experienced investors do not fully appreciate how much the effective federal funds rate has been suppressed since 2007 and the impact that raising this benchmark rate will have on our economy.

For 2000 through 2007, the effective federal funds rate averaged 70.5 percent of the 10-year rate, and in 2008, it averaged 72.1 percent. But from 2009 through 2012, it averaged a scant 5.5 percent of the 10-year rate.

Will Team Obama face economic reality?

President Obama and his circle of advisers appear to live far from the difficult choices investors and ordinary working people confront each day.

Five years into America’s unsustainably high-deficit spending and aggressive monetary easing, the world watches a new drama playing out between the U.S. government and our central bank.

If the Federal Reserve System succumbs to political pressure and fails to raise interest rates in the face of mounting inflation, foreign investors quickly will unload holdings of dollar-based securities.

Alternatively, increasing interest rates to levels in line with experience before 2008 will wean the U.S. economy from the low-cost borrowing causing pain throughout the nation, including at the Federal Reserve System, whose balance sheet is stretched pitifully thin.

At year-end 2012, the equity capital of combined banks in the Federal Reserve was $54.7 billion, or just 1.88 percent of $2.917 trillion in total assets.

Should inflation and foreign investors force the Federal Reserve to raise U.S. dollar interest rates, America and the world must hope that benign, solvent forces stand ready to do the tough work we should have done starting in September 2008.

Charles Ortel serves as managing director of Newport Value Partners (newportvalue.com), which provides economic research to executives and to investment firms.

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