By Krassimir Petrov, PhD:
Once again the Fed, the mainstream media, and Bubblevision continue to relentlessly propagate the myth that the slowing U.S. and global economy will ease inflationary pressures. In addition, the current Credit Crisis and the ongoing collapse in commodity prices have encouraged deflationists to reiterate their beliefs that deflation is inevitable. These views represent two different approaches of the same myth. Investors should not fall for it.
Given the recent fall in prices in a broad range of commodities, we are assured that inflation is no longer a problem, indeed that the real threat is deflation; inflation is supposedly transitory and inflationary expectations are “well anchored”. We are led to believe that “recessions cure inflations.”
Nothing can be further from the truth. On the contrary, given the current macroeconomic environment, the massive government stimulus of hundreds of billions of dollars in rebate checks and a series of bailouts will most certainly translate in much higher inflation and little or no economic growth. One must prepare for the reality that the government’s “cure”, as Peter Schiff has repeated so often, will be worse than the disease.
In coming years, investors must expect a lot more inflation and adjust their portfolios accordingly – their survival depends on it. Our job here is to outline the importance of the inflation-deflation debate, interpret its meaning, provide some historical evidence, and present the arguments for future economic development with its investment implications.
1. Importance of the Inflation-Deflation Debate
For any investor, the most important issue in today’s macroeconomic environment is the correct forecast of future inflation. Its essence boils down to strategic asset allocation. In a strong deflationary environment, the prices of stocks, commodities, and risky bonds fall; cash, cash equivalents, and safe bonds are the winning investments. On the other hand, in an inflationary environment, cash, cash equivalents, safe bonds, and most stocks rapidly lose value for two reasons – due to rising interest rates and due to loss of purchasing power; commodities, gold, and other tangible assets are the winning investments.
The general importance of the inflation-deflation debate lies in its investment implications – inflation means investing in one set of assets, and deflation in a different set of assets. Assets appropriate for an inflationary environment can lose dramatically in a deflationary environment. The opposite is also true – assets appropriate for a deflationary environment can lose value dramatically during inflation.
Thus, the survival of investors depends crucially on the correct forecast of future inflation. The debate on this subject has dominated the financial landscape this decade and will surely continue to dominate it in the near future.
2. The Meaning of the Inflation-Deflation Debate
Proponents on either side of the inflation-deflation debate offer all sorts of arguments that can be extremely confusing for ordinary investors and even for many professional investors, money managers, analysts, and economists. The confusion lies in the very definition of inflation. For one group of analysts, inflation means “rising prices”; it requires one set of arguments and statistics. For the other group, inflation means “an increase in money and credit”; it requires a radically different set of arguments and statistics.
There is even a third group of “analysts”, typically presenting on CNBC, which conveniently mixes up the two in order to better present their case. They do not bother to distinguish between the two – they have a muddled thinking, a clear agenda, and choose whatever argument suits them best. The intelligent investor should approach these analysts critically – or better yet, just ignore them altogether. I prefer to use them mostly as contrarian indicators.
The analytical confusion is best resolved with proper definitions. The term price inflation is often used to refer to increasing prices, while monetary inflation refers to increasing money and credit. Each requires a different analytical set.
Economists have also coined a term for what is, in my opinion, most likely to come: stagflation. It means a stagnant economy that grows well below its potential or is in outright recession, yet inflation is above the acceptable level and rising. An alternative definition of stagflation is that this is a state of the economy in which both inflation and unemployment are rising.
One other commonly used term is reflation. It refers to the conduct of expansionary monetary policy-monetary inflation-immediately after a recession that was triggered by a preceding tight monetary policy. One example of reflation is Greenspan’s slashing of interest rates after the economic slowdown of 2001, which in turn was preceded by monetary tightening in 2000-2001.
The analytical confusion related to inflation is generally compounded by differences in schools of economic thought. Monetarists and Austrians posit that monetary inflation is the cause of price inflation; their focus is on money supply and monetary aggregates. Austrians further refine the Monetarist approach by introducing a sophisticated theory of the boom-bust cycle and differentiating between inflationary and deflationary booms and between inflationary and deflationary busts.
Modern Keynesians indirectly posit that economic growth drives price inflation; their focus is on money demand affected by the interest rates that the Fed determines through monetary policy. In theory, monetary equilibrium (money supply equals money demand) is maintained by adjusting (increasing or decreasing) the credit that the financial system supplies. Even though the differences between Keynesians and Austrians are foundational-one focusing on money supply and the other focusing on money demand-they can be nevertheless reconciled with the appropriate understanding and interpretation of the concept “inflationary expectations”. However, this reconciliation is well beyond the scope of this article and is best reserved for scholarly work elsewhere.
3. Historical Evidence
First, it is important to consider historical evidence regarding the claim that a slowing economy results in slowing inflation, casually presented as “recessions cure inflations.” History firmly rejects this oversimplified and naive view. The very essence of this view is that stagflations are uncommon, atypical, and anomalous in nature, and thus very unlikely in the real world. However, the truth is that there are hundreds of 20th century examples of stagflations around the world. If the U.S. audience is still not convinced, then a number of specific examples from the U.S. should hopefully provide compelling evidence. Here are four specific examples:
1958 Recession. Murray Rothbard has pointed out on many occasions that the recession of 1958 was stagflationary in nature. Modern-day economists prefer to completely ignore it as if it never happened. Many are simply not aware of it. Some say it was not important because it was short and shallow. Some find it an example of an inconvenient truth. In reality, the economy contracted from an annualized GDP growth of +3.9% in 1957 Q3 down to an annualized -10.1% by Q1 of 1958; at the same time, using official statistics on a 12-month basis, inflation was running at 3.3% at the beginning of the recession and accelerated to 3.6% in the depth of the recession during Q1 of 1958. Thus inflation was worsening as the recession was deepening. This is the first example of a classic stagflation in the U.S.
1973-1974 Recession. The initial trigger of this recession was the first oil shock that resulted from Arab oil-exporting countries imposing an oil embargo on the United States and its allies for their support of Israel during the Yom-Kippur War. The mainstream misleadingly claims that this First Oil Shock caused the recession. What is not well understood is that before the recession, the U.S. had experienced strong inflation, and the Fed was attempting to tame that inflation by reducing the growth of credit in the U.S. financial system. It is remarkable that the Fed had already raised the Fed Funds rate from 3.3% in February of 1972 to 10.5% in August of 1973 – prior to the onset of the First Oil Crisis in October of 1973. As a result of this tightening, a major economic slowdown was in the pipeline. But the question that remains unanswered is “why would the Fed be raising so drastically interest rates unless it had a severe inflationary problem on its hands”
The result was stagflation because the shock resulted in a rapidly slowing economy, forcing the Fed to stimulate the economy with what later turned out to be excessively stimulative monetary policy. This was a grave mistake that the Fed was bound to repeat many times in the future, especially after the 2001 recession. Rather than allow the shock to work its way through the economy and let it slip into a recession, the Fed effectively “monetized” the shock. In doing so, it rapidly increased the money supply and allowed the dollar to depreciate. This in turn resulted in rapidly rising prices of imports. Given that the world was still on a post-Bretton-Woods dollar standard, the result was a global stagflation.
1980-1982 Recessions. During the period of 1975-1978, the U.S. economy was back to inflationary growth. Prices were rapidly rising and peoples’ expectations of inflation rose substantially. The recession, which technically started in early 1980, was triggered this time by the Second Oil Crisis, related to Iranian protests and supply disruptions related to the pre-Iranian Revolution. This was later exacerbated by a widespread panic on the markets associated with Iraq’s invasion of Iran and the beginning of the Iraq-Iran War. Oil prices skyrocketed from $15 to $40 and the U.S. economy fell into a deep recession. This was also the time when Jimmy Carter appointed Paul Volcker as Fed Chairman with a mission to fight inflation. Prices had doubled during the 1970s, the money supply was expanding briskly, and interest rates continued to rise reflecting rising inflationary expectations. Many were calling the inflation rate, at about 15%, “Latin American”.
Volcker announced a Draconian monetary policy on October 6, 1979. Dramatic increases in the Fed Funds rates from 11% in September of 1979 to an average of 17.2% in March 1980 resulted in a sharp recession during the second quarter of 1980. Then the Fed flinched and begun a massive reflation effort by rapidly slashing interest rates in five months from 17% to 9% (from March to July of 1980) that resulted in a stronger than anticipated recovery with surprisingly strong and accelerating inflation.
The Fed began tightening monetary policy again and induced a vicious second recession in 1981-1982. At one point the Fed funds rate touched 20%. The recessions were highly inflationary as inflation ran again at about 15% at the beginning. At the end of 1981, despite a vicious and prolonged recession (declared then to be the worst since the Great Depression), inflation had fallen to only 9%, still an extremely high number by any standards. One thing is sure: the recession did not cure the inflation, as inflation (disinflation) lingered for another decade.
2001-2002 Recession. The mainstream would never admit it, but the 2001-2002 recession was stagflationary in nature. To see this, one cannot look at government inflation statistics that are doctored with substitution effects, hedonic adjustments, geometric weighting, etc. When using more realistic inflationary numbers, as reported by John Williams from Shadow Government Statistics, it is easy to see that the recession was stagflationary in nature. According to Williams’ data, inflation during 2000 held steady at 10%, though it was officially reported at almost 4%.
At the end of the recession, during the second quarter of 2002, inflation had fallen to almost 8%, compared to the official 2%. It is important to understand that post-9-11, the Fed reflated aggressively and intervened massively in the money markets to stimulate the economy, which in turn reignited inflationary pressures. Instrumental in this reflation was the hedge fund community (“The Leveraged Speculator Community”) emboldened by the Greenspan Put, a topic that the reader should pursue on his own by becoming thoroughly familiar with Doug Noland’s “Credit Bubble Bulletin”
At this point, some general comments are in order. First, it’s important to understand that the whole decade of the 1970s is considered to be stagflationary. Most of the decade was characterized with stagnant growth and rising inflation. Only when inflation became widely recognized and politically unbearable did the Fed react accordingly. The recessions highlighted above (during the periods of 1973-74 and 1980-82) represent the worst of the period.
Second, during some of the above periods of observed recessions, inflation did fall from extremely high levels to still relatively high levels, but the recession itself did not resolve the problem of inflation. Basically the recessions had to be much longer, much deeper, and much more painful in order to allow the “cleansing” process (major bankruptcies, liquidations, and bad debt write-offs) to “flush” the malinvestments from the economy and begin growing again on a healthy foundation.
The third important point is that economic slowdowns usually trigger massive reflationary responses from the Fed that reignite inflation. Such was the response in 1958, then again in 1970 (not described here), in 1974, 1980, 2001, and currently in 2007-2008. Anytime the Fed has responded by massively reflating the economy, the typical result has been stagflation. In essence, by reflating the economy, the Fed prematurely aborts the bust (recession) part of the cycle and its beneficial adjustment processes and quickly drives the economy back to its pre-recession inflationary levels.
4. Monetary Inflation
The current environment is certainly stagflationary from a monetary perspective. The economy is slowing, yet monetary indicators are rapidly expanding and pricing pressures increasing.
The strong inflationary environment preceding the real estate bust prompted the Fed to raise the fed funds rate in baby steps over 15 times. At every point, the Fed was “behind the curve”.
While raising interest rates, it allowed money and credit to expand faster and faster. The best indicator for that is the Total Credit Market Debt Outstanding, reported by the Fed and provided in the chart below by Prudent Bear. In essence, during the “tightening-lite” cycle, the Fed actually implemented loose monetary policy that resulted in steadily rising outstanding debt.
Since the beginning of the real estate bust-and especially since the beginning of the Credit Crunch-the Fed has been especially accommodative. Bernanke rapidly slashed interest rates from 5.25% down to 2% in about half a year. The Fed has introduced a plethora of channels and mechanisms to inject extra liquidity into the banking system, such as the Term Auction Facility (the TAF). It is estimated that since August 2008 the Fed has injected over a half a trillion dollars cumulatively into the system. The most extraordinary development is that over the last two months the Fed has ballooned it balance sheet by about 80%. This is an extraordinary monetary inflation, unprecedented in the history of the Fed, which is likely to surface in coming months and years as deteriorating price inflation. It also appears to be only the first installment in the ongoing battle against the forces of deflation.
Probably the best testament to the accelerating monetary inflation over the last couple of years is John Williams’ reconstruction of the discontinued M3 money supply series. In the middle of 2006, money supply was growing in the 5-7% range, but since the beginning of the credit crunch growth has reached the 15-17% range. This increase in money supply represents an extraordinary accumulation of a “built-in” monetary inflation, which will eventually burst into consumer price inflation.
5. The Deflation Scare
Everything on the monetary side points to more inflation in the future. Nevertheless, over the last half a year-especially since the “Credit Crunch” has gained strong momentum-deflationists have been emboldened to proclaim yet again that the economy will spin into a dreadful deflation, dragging everything in sight with it. I can understand the deflationist warnings, as I was once a deflationist, schooled by Robert Prechter, the Dean of the Deflationist School. His book Conquer the Crash is the ultimate reference book on deflations, The Deflationist Bible. Whether one believes in a coming deflationary depression or not, one must nevertheless read the book and understand its arguments.
The quintessence of Prechter’s book is that inflationary booms cannot last forever; here Austrians will eagerly agree. However, Prechter argues that inflation cannot last forever and that deflationary forces will overwhelm the financial system, so that the economy will tailspin into deflation; here Austrians will disagree, as they admit to the possibility of an inflationary bust, i.e., a stagflation.
Prechter provides (in Chapter 13, p. 130) three limits to credit expansion that we can actually observe. With these, we can determine whether monetary inflation can continue or not. His first limit on credit expansion is the rising price of gold; the second is the falling dollar, and the third is rising interest rates (due to rising inflationary expectations) and corresponding falling bond prices, which in itself is strongly deflationary. In Prechter’s terms, the three countervailing forces to inflation come from the gold market, the bond market, and the currency market.
Over the last six years, I have found these criteria to be extremely helpful, especially in determining whether the environment would turn deflationary any time soon. It is easy to analyze each and see if any currently represents a genuine limit to credit expansion.
- Price of Gold: The price of gold has been steadily rising for the last seven years and it has not yet deterred the Fed from inflating. Clearly, whether gold rises to $1,000 or $2,000 or more, the Fed will remain unmoved by its rise. Also, just because the price of gold has been correcting for the last 3-4 months does not mean that deflation is here. An intermediate correction does not make a secular trend!
- Dollar. Moving to the second limitation, apparently the Fed pays only lip service to the government’s Strong Dollar Policy. In reality, the Fed seems to like the idea of a falling dollar, as long as the fall is orderly. The Fed would most likely be pleased to see the dollar a lot weaker in the future, provided again that the devaluation is “orderly”.
- Interest Rates. This third limitation is no limitation at all to an Inflationist Fed hell-bent on preventing deflation. The Fed has devised a number of ingenious approaches to support the long bond and has even stated in public that, if necessary, it will monetize the long end of the curve to support high bond prices and respectively low bond yields.
The deflationist arguments resting on gold, the dollar, and the long-bond yield apparently present no problems for the Fed at all. In reality, the Fed can inflate at will, and this is exactly what it’s doing!
At this point, there appears one, and only one, limitation that will force the Fed to slow down its monetary inflation and compel it to raise interest rates – a Dollar Crisis associated with a flight out of dollars and a panic in the currency markets, triggering a colossal currency derivative crisis.
Nothing short of this will constrain monetary inflation. At this point, it is my opinion that so long as the dollar devalues in an orderly manner, or the dollar actually rises against other fiat currencies, the environment will remain strongly inflationary.
Other deflationists have raised a very powerful argument in their favor. Typically during an asset deflation, where the prices of stocks and real estate fall, there are no willing lenders and no willing borrowers, no matter how low the Fed lowers interest rates. This is dreaded condition is known as “pushing on a string”. The classic example is Japan since 1990.
The counterargument is straightforward: in modern fiat monetary systems: the Central Bank is always a willing lender of last resort and the Government is always a willing borrower of last resort. In order to prevent contraction of credit, the government can always borrow and the Fed can always monetize – credit contraction and deflation do not have to occur when the Fed and the government do not allow it to happen.
So far, it is more than obvious that the Credit Crisis has not prevented the Fed from its inflationary course, despite the rhetoric to the contrary. In reality, the Credit Crunch combined with a contrived deflation scare and a rising dollar has provided a cover for the U.S. government to increase its budget deficits and an excuse for the Fed to inflate further. All monetary indicators confirm that the Fed has been successful in this regard.
6. Price Inflation
Current price inflation data confirm all trends and expectations associated with monetary inflation. In recent years, both the official and the alternative indicators of consumer price inflation point steadily towards stagflation.
The price inflation chart above clearly indicates that since 2002 inflation has been steadily accelerating.
At the same time, as you can see in the chart below, economic growth has been steadily slowing since the beginning of 2004. The last three years represent a period of accelerating price inflation and slowing economic growth, irrespective of whether one uses doctored government statistics or the SGS-adjusted numbers.
Compelling evidence of stagflation has emerged from the statistics so far this year. A sequence of weak jobs reports have convinced many renowned economists that the U.S. economy slipped into a recession either in December of 2007 or in January of 2008, even though the mainstream continued to opinionate even in August of 2008 whether the U.S. will slip into a recession. Most likely, the U.S. economy has been in recession over the last 5-6 months, while at the same time inflation has been steadily rising and approaching levels uncomfortable even for Wall Street and FOMC members.
While many openly dispute the recession hypothesis by claiming that the U.S. can dodge a recession, at this point pretty much everyone agrees — even Fed Chairman Ben Bernanke — that the U.S. economy is stagnant, growing close to zero percent. At the same time, observers across the board have acknowledged rising consumer price pressures.
Literally every meaningful indicator is pointing to continuous price inflation in coming years. The most obvious indicator is inflation’s momentum. Despite macroeconomic stagnation (or outright recession), inflation has continued to accelerate.
The second obvious driver of price inflation is a steadily weakening dollar against all other currencies, despite the dollar bear market rally during the last 3-4 months driven most likely by Wall Street deleveraging. Since the beginning of the Credit Crunch, the dollar has fallen between 10 and 20% against a wide basket of currencies, suggesting steadily rising prices of imports, while the recent relief rally will most like prove to be an intermediate correction. More importantly, many exporting countries, like China and India, are reporting accelerating inflationary pressures in their economies, indicating rising prices in their own currencies, which in turn will translates into even higher prices in U.S. dollars.
The third driver is the rising price of energy on international markets. Rising crude and gas prices will filter eventually through consumer prices as production costs rise. In a sense, the “Third Oil Crisis” is unfolding in slow motion as the price of crude has doubled during the last year. Such a 12-month increase in the price of crude has always resulted in a recession coupled with rising price inflation, even though the price of oil eased after the price spike. In other words, spiking oil prices are highly stagflationary. While it is true that the oil has corrected almost 50% in few short months, the price of oil will resume its upward move; we have seen similar corrections many times before, most notably in January of 2007.
The fourth driver is the evolving “Food Crisis”. In my opinion, there is no food crisis and there is no shortage of food. There has been a small decrease of output in highly inelastic agricultural goods coupled with steadily rising demand that has resulted in food prices almost doubling in a very short period of time. This is a classic textbook example of basic Econ 101 that we typically teach freshmen in their third week of the semester.
For example, in my home country Bulgaria, there is no shortage of any agricultural commodity – any can be had, albeit for a lot higher price than a year ago. Similarly, during the last month I have been living in Saudi Arabia and I have never heard once anyone mention anything about food “shortages”. It seems to me that the journalists’ quest for sensationalism naively associates rising food prices with “Food Shortages” or with a “Food Crisis”. They show us images of emaciated children in poor countries caused by the Food Crisis, while the simple truth is that these poor are starving because their parents have low incomes and cannot afford the rising price of food. The root of the problem is not the lack of food, but the lack of income.
In reality, what has happened is that after so many years, food prices are finally beginning to catch up with other prices in the economy – with real estate prices and with stock market indexes, for example. Essentially, the whole commodity complex is making up for lost time during the 1980s and 1990s. Commodities still have a lot to rise in order to realign their values to stocks, bonds, and real estate; or alternatively, stocks, bonds and real estate prices must collapse relative to commodity prices. Here, I prefer a monetary argument: given that the Fed has been flooding the markets with liquidity over the last 9-12 months, it is unlikely that stocks, bonds, and real estate will adjust significantly downward, but much more likely that commodities will adjust upward, which spells even more consumer price inflation down the line. Rising commodity prices, just like rising oil prices, spell stagflation. Do not be fooled by the recent fall in commodity prices.
The fifth driver is the rapidly rising inflationary expectations. As an illustration, consumers feel that rice will be more expensive next month or next year, so they decide to stock up on rice, which drives its price much higher. Suddenly rice is hard to find, so consumers begin stocking up on all sorts of foods. That makes all food prices react violently upward, which in turn triggers governments across the world to impose export quotas, which in turn further feeds the buying frenzy. Now, consumers seeing all sorts of prices rising (such as imported underwear and apparel or necessities such as toothpaste and toilet paper) will rationally decide to purchase many of them in advance, in anticipation of more rising prices. The obvious result: even more price inflation.
The sixth driver is the government’s stimulus packages. This summer the consumer benefited from a few hundred billion dollar stimulus package and Ben Bernanke testified again in front of Congress in October 2008 that yet another fiscal stimulus is necessary. The consumer has plenty of options, like paying down debt and investing the money in stocks and bonds, but the most likely outcome is that the majority of money will be spent of food and energy, thus further driving their prices higher and further exacerbating an already acute inflationary problem.
The above is sufficiently important to warrant a detailed explanation. In essence, the current price inflation has squeezed the consumer to the point where a much larger portion of his income goes to food and energy. Demand for these two critical items is very inelastic, so most extra income will be directed towards them. The key to understanding the outcome is the fact that food and energy supply is also very inelastic – consumers can willingly pay higher prices, yet businesses cannot respond with increased supply of food and energy. The nature of providing (supplying/producing) food and energy is such that it entails significant lags in time, often three, five, seven or more years. Thus, increased demand for food and energy driven by the Bush stimulus package(s) will likely result in significant price inflation and little economic growth. As a counter-example, consider that if consumers were to decide to spend their stimulus package cash on massages and fitness trainers, it would result in booming massage and fitness industries hiring more massage therapists and fitness trainers to expand their services; with food and energy this won’t happen-it won’t translate into jobs or growth.
A host of other factors contributing to exacerbating stagflation can be offered here, but the overall message should be clear. Price inflation has strong, long-term drivers that are here to stay for many more years. Unless another Great Depression truly chokes consumer demand, inflation is only going to get worse.
7. Investing in Stagflation
(Chart reproduced with permission. Marc Faber Limited. www.gloomboomdoom.com)
In a stagflationary environment, stocks, bonds, and real estate are likely to underperform commodities and gold. This is the lesson of the stagflationary 1970s, when gold and energy outperformed all other asset classes and all other commodities. The chart above, which is reproduced from Marc Faber’s highly-recommended book “Tomorrow’s Gold” shows the performance of various investments during the stagflationary 1970s. I have every reason to believe that the coming decade will be a repeat of the 1970s. I also have good reason to believe that all major investment classes will perform similarly. Notice that stocks and bonds were the worst performing assets during the 1970s, while oil and gold performed the best.
by Krassimir Petrov, PhD
October 24, 2008
Source: Financial Sense