The Federal Reserve’s unexpected inter-meeting cut of 0.75% in the Federal Funds rate to 3.5% was accompanied by a sharp rally in the dollar bond market, as the 10-year Treasury bond yield dropped to 3.4%. With inflation well above 4% and rising, one can only ask: why? Why would anyone buy the obligations of a shaky deficit-ridden political system in a currency that appears fundamentally unsound? Usually, this column likes to answer the conundrums it poses the reader, but I’m damned if it has an answer to this one.

In the short term, the specter of inflation is looming ever nearer. Sharp reductions in interest rates and insertions of liquidity into the system, as have been undertaken by all the world’s major central banks outside Japan, have increased the supply of money chasing goods, at a time when commodity markets are already stretched. Hence, not only is the dollar likely to decline owing to the extra liquidity, but commodity prices are likely to rise further in terms of all major currencies. The result cannot fail to be accelerating inflation; as I wrote last week, I expect even reported inflation to hit an annual rate of around 10% by the end of 2008.

If inflation accelerates rapidly during 2008, bond prices must fall. A 3.6% return is wholly unacceptable in a currency suffering from 10% inflation; returns of 2% in yen, 4% in euros, 4.5% in sterling or even 13% in Brazilian real will appear more attractive to the savvy international trader. Consequently, at least in the short term, accelerating inflation will bring declining bond prices and rising long term bond yields, even though the Fed, the Administration and Wall Street will be using every endeavor to prevent such an unpleasant outcome, since it will wreck their strategy for saving the housing market.

Since the problem will initially be primarily one of inflation, it may be thought that Treasury Inflation Protected Securities (TIPS), indexed against inflation are an adequate solution. Unfortunately, they are not. For one thing their inflation index is subject to the “hedonic pricing” distortion, whereby reported inflation is adjusted for imaginary “hedonic” benefits and hence lags true inflation by close to 1% per annum. Since TIPS are fully taxable, and currently yield only 1.3%, it can be seen that the chances of getting a real after tax return higher than zero on TIPS is small. In addition, once bond yields have been corrected by the market to provide a reasonable real return on ordinary Treasuries, the yields on TIPS can be expected to increase commensurately and their prices to decline, providing investors with a capital loss.

At some point, probably around the inauguration of the new President in January 2009, the Fed’s low interest rate strategy will have to be abandoned as a hopeless and damaging attempt to roll back the market’s tides. At that point, Fed Chairman Ben Bernanke will probably be forced to resign, just as was G. William Miller in 1979 (and with much more reason than that unlucky and generally inoffensive gentleman.)

To replace him a new Paul Volcker will be appointed by the new President to deal with the inflation crisis. The incoming President will be fortified by the knowledge that the blame for inflicting inflation-fighting pain on the populace can be placed securely on the shoulders of his or her predecessor George W. Bush, who will be reviled much as was Jimmy Carter in 1981-82. It will be an ideal time for a change that blames the preceding administration, just as was January 2001, when an intelligent incoming President George W. Bush, could such a thing have been imagined, might have inveigled the Fed to raise interest rates, wring the excesses out of the system, and blame the pain on Bill Clinton.

The arrival of the new Volcker (the original Volcker – otherwise ideal — presumably feeling, sadly, that he was a little past the job at 82) would cause a further bloodbath in the bond market. While the long term value of US government bonds would be greatly improved by the neo-Volcker’s arrival, in the short term the neo-Volcker would need to raise the Federal Funds rate well into double digits, to match the accelerating rate of inflation. This would inevitably have a further depressing effect on the prices of the outstanding stock of Treasury bonds. A further depressing effect would be caused by the budget deficit; already running at more than $500 billion as the new President arrived owing to misguided stimulus packages and slow economic growth, it would rapidly soar beyond $1 trillion as the new higher financing costs caused a painful recession and themselves raised the government’s overall borrowing expenses.

Thus the short term outlook for fixed rate US dollar bonds is dire. Three factors, accelerating inflation, a sharp rise in short term interest rates and an exploding budget deficit, all make them likely to slump in price in the next 12-18 months. What of the medium or long term? Is there a chance that a 3.6% 10 year Treasury bond, however battered in the next year or two, might come to be seen as a good investment before its maturity?

There are three underlying trends that suggest that long term US Treasury bonds may be an even worse investment in the long term than in the short term. Combined, they suggest that a junk-level credit rating for the US government may be appropriate.

First, there is the social security system, which has been providing over $100 billion per annum towards plugging the deficit gap in the last few years, but is about to stop doing so and then after 2017 swing into sharp deficit. Contrary to Washington belief, this problem will be exacerbated by a continued high immigration of younger, less skilled people. Since poorer people require more services and pay relatively less into the social security system than rich people, the actuarial deficit will worsen, and it will become clear that the young and foreign-born are paying relatively heavy taxes in order to support a large retired native-born cohort with most of whom they have no genetic, ethnic or cultural links. Inevitably the political process will at that stage function in order to relieve these younger voters of their substantial net obligations, almost certainly requiring further heavy government borrowing.

The second actuarial problem is Medicare, whose costs are increasing considerably faster than Gross Domestic Product and have been for many years. Theoretically, this problem could be solved by delaying eligibility for Medicare sufficiently that its books balanced – after all the medical advances that cost so much are increasing human lifespans and health. In practice, it is almost certainly not possible to do this quickly enough, in that by the time the problem has been fully recognized the lump of retired beneficiaries will have overwhelmed the system, and it will be impossible to make them “un-retire.” Here the political omens of 2008 are for a further worsening of the situation. The Medicare fix promised by the Democrat candidates would increase costs more than revenues, thus worsening the actuarial position, as well as removing the opportunity to solve the program’s problem by delaying the eligibility age – if all are eligible, there will be no escape from the system’s vast costs.

Finally there is the problem discussed in this column a couple of weeks ago: that of the migration of an increasing proportion of US jobs to the Third World, and the consequent future decline in US relative living standards and very likely in absolute living standards. Moreover, emerging markets now possess an increasing proportion of the world’s capital. Thus even in a period of tighter money, when the US capital cost advantage would have been a most salient competitive factor, the transfer of manufacturing and high-level service jobs will not be reversed, or even greatly slowed.

The economics of this as it affects the US public sector are clear but unpleasant. If it had happened during the Coolidge administration, before welfare entitlements had been established, the transfer could have occurred smoothly, with little additional US unemployment and only moderate dissatisfaction in the workforce. However, with public sector programs in place for social security, Medicare/Medicaid and unemployment insurance, there is a major difficulty.

The US is currently in the position of General Motors in about 1970, splendid in its possession of a majority share of the US automobile market, and apparently invulnerable to competitive threat, yet in reality burdened with impossible welfare programs that a foolish management had negotiated during the good years. For General Motors, the future after 1970 was one of steadily slipping market share, from 60% of the US market to about 25%, of a steadily aging workforce, and of a retiree health benefit obligation that if valued appropriately is today worth far more than the value of the company itself. Had GM not undertaken its excessive pension and healthcare obligations, it would have had more capital to compete effectively, would have been less likely to lose oodles of money in every downturn, and might still retain primacy in the world automobile market today, albeit by a lesser margin than in 1970.

For the US, the position is the same. Its workforce will be older than its competitors’ and entitled to benefits that absorb an increasing share of the national income as its relative earnings decline. Importing new younger workers, except at the very top of the skill pyramid, will worsen the problem because they too will by immigrating obtain rights to excessive social and medical benefits. The extensive US welfare system will encourage early retirement and periodic unemployment as solutions to individual workers’ income problems, rather than enabling a smooth transition to a lower wage level. Both Medicare and Social Security’s current assumptions include a rise in the US workforce’s real earnings at a steady rate beyond 2050; if this does not happen the programs’ actuarial deficits will explode. Doubtless the government will attempt to solve the problem by borrowing yet more money; it will be apparent only too late that massive default lies at the end of that road.

In summary, like General Motors in 1970, the United States does not deserve its AAA rating and its obligations, particularly those denominated in the local “Bernanke pesos” should be avoided.

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(The Bear’s Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that the proportion of “sell” recommendations put out by Wall Street houses remains far below that of “buy” recommendations. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)