• INFLATION, DEFLATION ... OR STABLE PRICES?
  • Stagflation yesterday, the Goldilocks Economy today.
  • Where do things stand now?
  • Where do we go from here?
  • An aside on the US money supply.
• UPDATE: THE UNITED STATES STOCK MARKETS.
• UPDATE: JAPAN AND ASIA.

Regular readers of The Skeptical Investor TM will know that the two or three topics* I cover in each Issue are chosen on the basis that I believe them to be the most significant things happening globally and the most likely to drive events in the near term. (* Except for my occasional "Canucks' Corner" - a concession to the fact of being based in Canada.)

The first Issue, posted here in mid-June last year,discussed the then already generally overvalued United States stock markets, and touched upon the potential importance of what had been happening in the Thai stock market. I implied that events there might be presaging a worldwide economic contraction in a similar way that the problems that began in 1927 in what was then the Dutch East Indies were,we now know, early symptoms of the Great Depression.

It has certainly not been difficult since then to decide what topics to include each month. Only a couple of weeks after the launch of The Skeptical InvestorTM the Thai currency started its precipitous collapse, and history was being made. Although Wall Street and the mainstream financial media took a long time to wake up to the severity of what was going on in Asia - the collapse of the Hong Kong stock market in October seems to have been the event that finally (if only for a while) got everyone's attention - I have consistently focused on it. That, and the interrelated growing magnitude of the US Dollar assets "black hole" continue still as the two great global economic trends that must affect us all, and I expect to still be talking about both for a long time to come.

In this Issue I again deal with these two matters. I also make an attempt to tackle head-on the overriding question for investors now: inflation or deflation? I had also intended to touch upon something else that, though not yet making big waves, is getting close and is important enough that it eventually will:European Monetary Union. I hope to do that in the next Issue.

INFLATION, DEFLATION ... OR STABLE PRICES ?

Stagflation yesterday, the Goldilocks Economy today.

Are you old enough to remember stagflation? I am. Back in the 1970s America, the United Kingdom, and indeed most of the industrialised ecomomies of the world, were suffering from economic recession and growing unemployment but also at the same time quickly rising prices. That wasn't supposed to happen. According to what was then accepted economic theory (summed up by economists in the Phillips Curve) inflation and the level of employment were always positively correlated. Therefore there was a tradeoff between inflation and unemployment. Or, in other words, inflation was the price an economy had to pay for full employment.

The politicians and socialists loved this theory because (as has most of the economic claptrap of the last seventy years) it implied that politicians had power to create jobs and prosperity. But in fact the real world evidence even back then had never really supported it. That is not just something that comes from 20:20 hindsight - the World Bank can take credit that it had been pointing out since at least the beginning of the 1960s that chronic inflation was not the way to get a vigorous, fully-employed economy. There were good real-world examples to point to as well. For many years Germany had had low inflation with high growth whereas Britain had been suffering both high inflation and low growth. Both were large economies that ought not to have been ignored by the theoretical economists.

Today it is widely (unfortunately still not universally) accepted that stagflation was the inevitable long run result of socialist statism and the waste of productive capital through high taxation and government spending -resulting in less enterprise and wealth - and the creation of too much money - which is what was causing the inflation. Thus the treatment for the disease is obvious: lower taxes and smaller government to free up enterprise and elimination of excess growth of the money supply in order to control inflation. The United Kingdom under the courageous leadership of Margaret Thatcher vigorously applied these treatments and the nation that had been "The Sick Man of Europe" became what is today the strongest economy in the European Community.

During Ronald Regan's presidency The United States also cut taxes. It unfortunately did not also control the Federal deficit (which has ballooned) but we have to remember that this is still mainly afuture claim on the taxpayer, and American enterprise has never yet been subjected to the same confiscatory levels of taxation as were Britons before Thatcher, or Canadians today. Also the US Federal Reserve Board has undertaken a successful anti-inflation strategy, limiting the growth of the money supply and keeping interest rates relatively high. The outcome is that now the United States is experiencing the opposite of stagflation. It has been called "The Goldilocks Economy" - not too hot, not too cold - healthy growth, low unemployment and low and falling inflation.

The Goldilocks Economy seems to be a bit of a mystery even to the Federal Reserve. High growth and close to full employment is supposed to trigger inflation, but inflation has continued to fall. But why should that be such a surprise? Isn't it the hoped for outcome in a free-enterprise economy with a cautious anti-inflationary monetary policy? If the real world experience of the 1970s - stagflation - proved that there was no causal link between employment and inflation, why are we now disinterring that same trade-off to predict inflation ahead? That seems to be tilting at windmills.

Perhaps we can do a better job of trying to understand what is going on by starting with the facts and seeing where they lead us.

[EXTERNAL LINK]Economic Time Series Data.

1. An inflation-fighting Federal Reserve that kept a lid on the money supply, and has maintained fairly high real interest rates. In 1994, M3(broad) money stock increased by just 1.74%. In 1993 it was a mere 1.62%. As for interest rates, with inflation now at 1.4%-2.0% and the 30-year Treasury yielding approximately 5.9%, real interest rates are thus 3.9%-4.5%. Historically they average 2.5%-3.0%.

2. The strong US Dollar. Due to its huge size and diversity, the American economy is more self-contained than that of any other OEC country. Exports, whilst important, are relatively less so than for other economies so the effect of a strong currency on exports is not as crucial to the whole economy as it would be elsewhere. And at the same time it makes imported goods cheaper for American corporations and American consumers.

3. "Moderate" taxation and a free-enterprise business climate. Taxation in the USA is moderate in comparison with that in other OECD countries(I am not implying that it is therefore reasonable and justified!). Free enterprise is such an incredibly powerful engine of production and growth that it will thrive in conditions that are far from optimal. American readers will know that they are living in a hampered economy, but it is not nearly so hampered as it is where I live!

4. Expectations. The Federal Reserve's declared intent to fight inflation and its obvious success in doing so has reduced expectations of rising prices, and hence of higher interest rates. This helps the virtuous circle e.g. investors accept lower interest rates if they do not anticipate inflation. Lower interest rates encourage business investment(provided things otherwise look good, see item No. 3, above).

Emphasis has been placed by many analysts on productivity gains accruing from the introduction of new technology, especially computerisation, as an explanation for the excellent performance of the economy. No doubt it has had an effect, but it is almost impossible to measure, and anecdotal evidence often suggests that the benefits are dubious. I fully accept that it has positive productivity benefits, but believe that they merely are cumulative, building up on the other factors,and not of primary importance. This may be important, because productivity gains tend to be one-off, and, if they have indeed been a major factor in the last few years, they may not continue to be in the future.

The Federal deficit has had less negative effect than it would have had if Japan had not been helping out through its massive purchases of T-bills. If there were no one to buy these debt instruments, then that portion of the Federal deficit that the Japanese (and other foreign nations) are holding would have had to be paid for through higher taxes and/or issuance of money. (Note: in the process known as "monetising the debt" the Federal Reserve buys government bonds and simply creates money to do it).

My conclusion is that there is nothing in the data to suggest that price inflation has started to appear, and that this is not as unreasonable as many commentators have been suggesting.

However, the direct measures of inflation - the CPI and the PPI- are historical numbers. They are not in practice much use as predictors. What we should do is try to find leading indicators, and then assess them realistically in the context of the (rather positive)factors listed above.

Leading indicators that, at least historically, have had some ability to predict the direction and scale of inflation/deflation are (a) the monetary stock, (b) the government bond yield curve, (c) general commodity price levels,(d) the political environment, (e) changes in general price levels detected by corporate purchasing managers e.g. the NAPM Survey, and lastly, (f) big changes in the price of gold.

With one exception, all of these are currently neutral or mildly disinflationary. The yield curve in particular I find quite compelling. That is because it is an aggregate measure based on the pure expectations of all participants in the markets, and it has (again I must emphasisehistorically) been a better predictor of interest rates (hence, of the direction and rate of inflation) than professional economists as a group. At present it implies a continuation of low interest rates for the foreseeable future (and, still having a positive slope, suggests no deflation either). Commodity prices are falling. This so far only implies continued disinflation. Gold is a special case: it has been in a long grinding bear market but this has been exacerbated by central bank sales and therefore this cannot be raised as good evidence for deflation ahead. I see it only as a mildly disinflationary trend.

But the one exception is something so important that it does constitute a real inflationary threat: the money supply. I mentioned above how in 1994 the money stock was only growing at 1.74%. What I didn't mention is what has happened to it since then:-

Annual growth in M3:-

1997 .......... 8.87%
1996 .......... 7.33%
1995 .......... 6.02%
1994 .......... 1.74%
1993 .......... 1.62%

Even under otherwise perfect conditions, if the money stock grows too rapidly the result will be inflation. Historically, the resulting inflation has lagged money stock growth on the average by something like 18 months. But, as we have seen above, we do not have any price inflation at present although these numbers seem to imply that we should have.

First, we can eliminate the 1995 surge in M3. Given the rapid growth in GDP, the monetary data for the previous two years look to have been too low. 1995 was catch up.

But it would be difficult to argue that there has not been a significant loosening since 1996. That gives us two years - not too far outside the average eighteen month time lag.

I think that there are two factors that explain this slower than usual response. First, remember that with all the other helpful factors that have been in place, a powerful virtuous circle has been set up. There is, if you like, more "anti-inflationary capital in the bank" to be used up. Remember that even a pure monetarist economist would not claim there is a 1:1 correlation between money supply and inflation. [There is an indefinable factor that economists call the "velocity of money" in the equation]. Thus being on the long side of the historical average is not much of a stretch. And anyway it has happened before. In 1983, after almost four years of monetary moderation, the Federal Reserve released the brakes and the rate of money growth soared to 13% from 7%. Due to a strong economy and confidence in the strength of the dollar, inflation did not kick in until 1987.

Secondly though, there in fact has been a response - but in the prices of US securities instead of in general consumer prices. I mentioned "monetising the debt". What the Federeal Reserve is doing with newly created money is feeding it straight into the bond market - they buy government bonds. And because of the interrelationships between the bond and the stock markets, e.g. portfolio balancing, a lot of this money then moves quickly into the equity market, driving up prices. So the stock market is very sensitive to monetary growth. The bull markets in stocks and bonds are (in part) a result of the growth in the stock of money. This again is nothing new: the same effect is thought to have been partly responsible for the performance of the stock market leading up to the 1987 crash.

Where do we go from here?

The trend in the USA suggests a continuation of the current mild inflation or further disinflation. In the absence of a major economic shock (such as a stock market crash and/or a global recession) there is little chance of actual deflation: the money supply can always be pumped up to head that off.

I see no reason in the short-term to expect the CPI and/or PPI to begin to reveal any actual inflation. As long as they do not, I will be concerned about and closely watching only the leading indicators that I listed above, especially the money supply and the yield curve.

In the past, a period of monetary restraint by the Federal Reserve has usually been followed by abandonment of the policy, a surge in money supply and a surge in inflation. This happened in 1983. However, these failures have been because the economy was in recession. This is not the case now, so hopefully the money supply will not be allowed to roar out of control.

I also cannot see anything in the numbers that would prompt the Federal Reserve to tighten and raise interest rates. I think that they too believe that they still have some "anti-inflationary capital in the bank" that gives them a cushion and buys time. It is important to bear in mind that they are in a different situation now than they were a few years ago when there was chronic inflation. Then, they needed to actively reduce inflationary pressures: an unambiguous policy objective. Now that the USA has achieved both low inflation and strong growth, they have to try to keep things in balance: probably trickier to get right than an unambiguous inflation reduction policy. There is no formula that says exactly what the money supply should be, and the time lag before seeing the consequences is very long. I believe that this is what the Federal Reserve have been attempting to achieve; rather than that there has been any U-turn on policy. And because any increase in US interest rates would attract even more capital from Asia it would be very damaging there. In view of the fact that I certainly do not share the optimism of many that the Asian Crisis has bottomed, I expect this factor is going to remain in place for sometime to come.

The stock market bubble is also being,in part, fed by and is absorbing increased money supply.

In my opinion the potential consequences of the events in Asia and the Stock Market Bubble are both of much greater concern than the possibility of a surge in inflation occuring first. In any case will not undeniable signs that inflation taking hold again trigger a stock market crash? Both a global depression triggered in Asia and a market crash in the USA are potentially strongly deflationary events.

An aside on the US money supply

There was a surge in the money supply late last year. In November, M3 grew at an annualised rate of 14.6% (not seasonally adjusted), in December at 13.8% (nsa). The timing suggests that this was merely a temporary response to the Asian crisis.Perhaps related to cash flowing into money market funds, foreign capital flowing into the safety of the USA, creation of money by the Federal Reserve to buy back T-bills from the Japanese ... or all of these. It has even been suggested that liquidity was needed because "somebody big" (i.e. a large American financial firm) may have got in to trouble through exposure to Asia, though I seen no evidence to substantiate that. The numbers for January and February were better, and I am optimistic that the surge was an aberration. However, if double-digit rates of money creation continue, I will quickly get concerned about it. The upcoming money supply numbers for March and April are going to be unusually important in telling the story.

UPDATE: THE UNITED STATES STOCK MARKETS.

I say this because, perhaps even more quickly than we pessimists expected, the profits growth needed to justify the valuations looks to be evaporating, yet the market continues to set new records. Now it is obvious that it is, and for some time has been, a bubble, driven by momentum and liquidity, not by underlying valuation.

"This quarter, rather than ending up with earnings reports showing 12% to 15% year over year growth, the actual growth will come out far less, and perhaps very close to zero." (Schwab Briefing, 16th March 1998).

This is not just the usual cautious pre-announcment downgrading of earnings estimates (done by analysts so that they are likely to be on the"right" side of the actual numbers once they are released). No, the estimates are being slashed, and across many sectors, not merely high flying technology stocks.

The Asian Crisis is hardly yet involved in this. And such a slowdown ought to be expected. When you have as attractive an economic climate as has existed in the United States for several years,new corporate investment soars - but eventually levels off as all the new projects come into production. The signs are there: I suspect for example that one of the causes of the huge share buybacks that we are seeing in the United States is that there are few or no attractive projects in which to invest cash flow.

It is hard to deny what is going to happen: I personally have little remaining doubt that we are in for a crash (not just a reversal and bear market). And it will be nasty. What other outcome is now possible?

Look at charts of the Dow Jones Industrials in 1929, gold in 1980, the Yen in 1985, the Nikkei-Dow in 1989/90 ... this is how raging bull markets end.

Those investors holding on to the bitter end apparently think they can spot the signs and get out of the way. OK. Then why are they not heeding the earnings downgrades? What more do they need? The fact is that most investors will not, cannot, get out of the way. The most likely scenario now is a sudden, apparently inexplicable crash.

UPDATE: JAPAN AND ASIA.

Japan in particular looks to be in exactly the sort of economic trouble that I have been expecting. It is in recession and there is price deflation of assets, property, and, now consumer goods. The Nikkei Dow Index is back under 16,000 again. Domestic demand is falling. Unemployment is rising. The anticipated credit crunch has definately arrived: banks are refusing to roll over loans, calling them in early or asking for more collateral, and are generally refusing to extend new credit. The Japanese Government Bond yields had previously tumbled to a record low of 1.470 (deflation) but are now rising again because of expectations that Japanese sovereign credit will be downgraded. A series of support and stimulatory packages put in place by the government have achieved nothing in the real economy (their only effect is to boost confidence and prices on the stock market for a short time). The Japanese banks are in serious trouble. It is the position of The Skeptical InvestorTM that Japan has entered a deflationary contraction that cannot be stopped and which will have to run its course. The government looks to be taking rather a similar view: recently Prime Minister Hashimoto stated quite bluntly that the sort of measures for stimulating domestic demand that the USA is pressuring Japan to introduce are not an option - because they won't work. He said that something will be done "in our own way" but it is difficult to see what that might be.

I have discussed in previous Issues the likely effect a severe deflationary contraction in Japan will have on the global economy. To judge by the enormous pressure that the USA and other countries are putting on Japan to "do something" such a pessimistic outlook is no longer particularly controversial.