Thinking Things Over              February 12, 2012

Volume II, Number 6:   Is Inflation, a Stagnant Economy, and Lower Standard of Living in Our Future?? 

By John L. Chapman, Ph.D.                                                                                                                     Washington, D.C.

Despots and democratic majorities are drunk with power. They must reluctantly admit that they are subject to the laws of nature. But they reject the very notion of economic law . . . economic history is a long record of government policies that failed because they were designed with a bold disregard for the laws of economics…… True, governments can reduce the rate of interest in the short run.  They can issue additional paper money.  They can open the way to credit expansion by the banks.  They can thus create an artificial boom and the appearance of prosperity.  But such a boom is bound to collapse soon or late and to bring about a depression.      — Ludwig von Mises

There is the possibility…that, after the rate of interest has fallen to a certain level, liquidity-preference may become virtually absolute in the sense that almost everyone prefers cash to holding a debt which yields so low a rate of interest. ….if such a situation were to arise, it would mean that the public authority itself could borrow through the banking system on an unlimited scale at a nominal rate of interest.       —  John Maynard Keynes

Introduction: The Prologue to Today and the Current Situation Summarized

On August 15, 1971, President Richard Nixon unilaterally terminated U.S. obligations under the 27-year old Bretton Woods monetary framework, and with it the U.S. Dollar link to gold.  The world became at once a global economy based on government-run fiat currencies, that is, national currencies managed by government-dominated central banks.  Gold was, for the first time in 2700 years of recorded human history, nowhere in the world used as a universally-accepted monetary medium.

What followed was, for students of sound money, predictable.  The M1 money supply grew 17% in the next two years, until Nixon era wage-price controls were phased out.  And then, during the nine years between 1974 and 1982 inclusive, the money supply grew another 81%.  Real output (GDP) growth averaged 2.0% per annum in the United States during that time, and other than the 1930s, this was the worst sustained period for economic growth in U.S. history — until the equally sclerotic period after 2000 (1.9% GDP growth in the U.S. since then).  Two percent growth was well below the long-term 20th-century (and post-war) growth rate of 3.4%, and this period is remembered as a desultory time.  Book-ended by Watergate, a Middle East war, and the Arab oil embargo in the beginning, and the brutal 1981-82 recession at its end, it was also an era of terrible inflation in the U.S.: during those nine years annual price increases averaged just over 9% per annum, topping out at 13.5% in 1980 and dooming the Carter Presidency.

Unemployment was also elevated during that period, by historical standards: it averaged 7.3% across those nine years, topping out at 10.8% in late 1982, a post-war high that still stands.  Meanwhile private investment as a percentage of GDP averaged around 12% during this period, nearly 1.5 percentage points below the subsequent high growth years of 1983-2000.  Lastly, the Dow Jones Industrial Average, which had flirted with the 1000-level in both 1966 and 1972, sunk to a secular low of 776 in August, 1982, with U.S. equities having lost nearly 70% of their inflation-adjusted value across those 16 years.

Why do we recount a long-ago episode of torpor in U.S. economic history, a period so forgettable that it became known by its own unique moniker of “stagflation?”  Unfortunately, there is rising talk of a return of stagflation here in the U.S. in coming years.  Both the economics profession and the investment community are currently locked in intense debate about the future course of prices in the United States, what the implications might be for output and employment growth, and possible correlative effects on asset returns.  In the essay that follows we examine inflation signals such as they have surfaced in the context of updated policy (based especially on the Fed meeting January 24-25), and sort out the “possible futures” that might ensue, including investor implications.  We produced a fairly extensive review of current monetary policy and its likely impact just a month ago, and stand by the conclusions reached there, summarized here as a useful point of departure:

….we feel highly confident that there will be no recession in the U.S. this year, absent any panic-induced retrenchment from troubles in Europe or war in the oil-producing regions of the Middle East.  Indeed there are reasons to believe the U.S. economy will be solid across 2012 in terms of GDP and jobs growth, and hence rising stock prices seem likely in U.S. markets (tempered of course by countervailing challenges elsewhere around the globe)……

…..the Fed has been intensely monitoring developments in Europe for the last two years.  In stark language in November, in fact, the Fed expressed serious concern about Eurozone growth and financial system trouble in 2012.  It may well be that, anticipating the need to meet dollar demand in the Eurozone, the Fed has decided to create for itself “capacity” for lending and swap operations in Europe in the time ahead. Hence a decision may have been made to offload or not replace maturing MBS assets.  For now we do not see this as problematic for intra-U.S. economy issues.  It is, however, yet another warning about the serious trouble Europe may be in.  While frustrated by the opacity of ECB and major Eurozone bank balance sheets, and equally so by a concomitant lack of knowledge of the level of exposure of U.S. banks and corporations to Europe, we have wondered for some months now, what does the Fed know, that we do not know?  All this is to say, our prediction is we are going to see a rise in swap lines to Europe, and we think the monetary base may well float back to higher levels in the months ahead.

Indeed, bringing this commentary up to date does show that in the first six weeks of 2012 (through February 8), the monetary base is up more than 5%, back near its all-time high post-QE2 last year:

Chart I. Adjusted Monetary Base, 1984-Present (Log Scale)  

We prefer to display such graphical data over time in logarithmic form per the above, as it shows equiproportional changes in magnitudes across time.  We trust readers have by now gotten accustomed to this and similar charts depicting the recent explosion in the growth of the U.S. money supply, but it is still worth pointing out the “breathtaking” nature of this chart — and, as we discuss below, the gamble it represents.  Suffice it to say for now that the Fed’s move from roughly $800 billion in the base in the early fall of 2008, to $2.8 trillion after QE1 and QE2 last spring, is — literally — unprecedented in world history (for students of economic history, it is also worth mentioning how small the “blip” in the monetary base appears in this chart on the eve of Y2K — Chairman Greenspan had made a point of assuring global investors of heightened Fed liquidity at the time, but the $40 billion temporary increase in reserves around the 4th quarter of 1999 — at the time a 15% increase — looks minuscule in comparison to the fall of 2008 and beyond).

As readers know, the Fed began to pay interest on commercial bank reserves in October 2008 in order to have a tool available to modulate new money creation through the commercial banking system: banks now have a higher cash flow hurdle in creating loan assets, and this is one reason for the huge elevation in excess reserves parked at the Fed (now at $1.6 trillion).  Additionally, while the M2 monetary aggregate, which includes M1 (currency and checking deposits in the main) plus savings and time deposits along with money market deposit funds, has grown 25% in three years and 2% in the last three months, the velocity of M2 — its total annual turnover in the economy — hit a new all-time low (since the Fed has tracked the data back to 1958) of 1.59 in the fourth quarter of 2011, as shown in the chart below:

 Chart II. M2 Velocity (1958-2011)

M2 is of course a broad aggregate — now approaching $9.8 trillion — that entails a wide swath of foreign investors and dollar-holders, and so does not always move in close correlation even with the Fed’s changes in the monetary base; hence, the reasons for secular changes in M2’s velocity are many and varied.  But it is still fair to point out that the move down from 1.9 just four years ago implies nominal GDP is at an annual run rate of at least $2.4 trillion less than it would be had that stayed constant or been restored.  And in the present context this signifies heightened investor and consumer nervousness about the future.

This in our view is the single biggest data point Mr. Bernanke is viewing with respect to inflation expectations, which the Fed says remain “anchored” and “subdued”.  Combined with slackness in the economy led by housing, stunted real wages in the U.S., Eurozone and Middle East tension-led demand for global dollar liquidity, and slowing export growth, the Federal Reserve is confident that its long run inflation target — and targeting is now indeed a feature of Fed policy — of 2% can be met (year-on-year, consumer prices rose 3% in the U.S. through January, with non-core items in food and energy much higher).

Mr. Bernanke is also known to be worried, if not mystified, by the continuing slow recovery in private capital investment of all types.  The following chart shows the still-tepid recovery in gross investment in the United States:

 Chart III. Real Gross Private Domestic Investment, 1947-Present (Log Scale)

As a percentage of GDP, investment hit a 35-year low in 2009 at 11.4%, and is only back to the 13-13.4% range in the last two years (approaching $1.8 trillion in 2011, and down from the 15-17% range of recent years).  To the degree that investment drives new jobs which in turn raises incomes and consumption,  the Fed solons see continued relative flat-lining in consumer prices.  And the Fed has made no secret that it is concerned in general about the sclerotic level of corporate/investor and consumer confidence in recent years, as evinced by corporate cash on the sidelines and consumer liquidity (which, as a percentage of personal income, is 25% higher than it was before the recession).

And so as a result of all this, the Fed announced on January 25th some fairly major “new” news: an 18-month extension of its de facto zero-interest rate policy (“ZIRP”), now stretched out another three years, an explicit target for personal consumption expenditures below 2% in 2012, tepid long term growth in the 2.3-2.6% range per annum (well below historical norms above 3%), and a qualitative statement to the effect that if the Fed’s twin mandate of stable prices and full employment were ever a source of conflicting policy aims, that in the current environment the Fed would err on the side of economic growth.  Clearly there is little concern about inflation, which has averaged only 2.3% since 2000, for the next several years.

Is Mr. Bernanke Correct That Inflation Presents No Concerns? No.

It seems to us, however, that the Fed is being “too clever by half.”   There are several indicators that prices will increase with a concomitant pick-up in economic activity.  First and foremost, commercial and industrial loans are up 10.2% year-on-year through December 2011, and loan growth has risen steadily for 15 straight months, including through last year’s slow quarters.  Key leading price indicators such as the producer price index, auto sales, and raw employment growth (along with hours worked) are all up smartly across the last year.  Along with inflation-sensitive item categories such as food and energy, commodity prices are up across the board, and commercial bank credit extended (of all types) is now at $9.46 trillion and approaching its 2008 nominal high.

The most telling statistic of all, though, is the trade-weighted value of the U.S. dollar, against all currencies, as per the following chart:

Chart IV.  Trade Weighted Value of the U.S. Dollar, 1995-Present (1997=100) 

Since the beginning of the 2003 recovery, the dollar has lost over 28% of its value globally (that is to say, against all other currencies).  This can only portend rising prices and a declining standard of living in the United States over time, and markedly so as and when the burdens of U.S. fiscal policy come home to roost here in the U.S.  That is to say, what is remarkable is how a global reserve currency that is still used in over 63% of all international transactions (albeit down from more than 90% a generation ago), and that is thus the beneficiary of a persistent global demand for dollar-denominated assets including cash, is still nonetheless in long-term secular decline in value around the world.  This can only worsen as the U.S. grapples with a debt-to-GDP ratio that has now breached 100% and continues to climb, through higher taxes and lower profits, investment, and economic growth.

As global demand for dollars falls, velocity — still well below pre-crisis levels – will pick up.  Matched with a decline in excess reserves due to stronger demand for loanable funds here in the near term, M1 and M2 will continue to grow, leading to a jump in prices well above the current 3% range (the 2011 CPI in the U.S. will be finalized at close to 3.5%).  This is indeed the analogy we see to the 1970s:  M2 velocity jumped at the conclusion of Nixon’s price control program and inflation rates shot up, dipped through the 1974-75 recession, and then shot up again.  As we have pointed out in the past:

… gains in velocity are not necessarily harmful if matched with gains in productivity; in Fisherian terms, where MV=PY, V can increase when Y is increasing and not necessarily see P rise as well. If however M and V exhibit increases during a period when investment has been stultified, P may bear the brunt of increasing nominal income levels.

But this only adds to our worry: there have been spectacular gains in productivity in the last three years which must per force now slow.  This is one key reason, in fact, why the Congressional Budget Office recently issued its updated forecast for 2013 GDP growth and placed it at 1%.  This itself is a concern, for the CBO is notoriously optimistic (e.g., in August 2011, it revised its 2011 full year forecast for GDP growth to 2.3% — the final 2011 growth number will be around 1.7%)!  And so of course this is indeed a recipe for a stagflationary future.

Summary

Our colleague at Alhambra Partners, Joe Calhoun, likes to enunciate what we have come to refer to internally as “Calhoun’s Golden Rule” for sustainable growth: that is, that long-term sustainable growth in the U.S. will be guaranteed when we see three simultaneous conditions met and maintained:  (1) a rising dollar, (2) rising equities, and (3) a falling gold price (and indeed, much is subsumed in the simultaneous attainment of the three: viz., a strong dollar encourages forward-looking investment that takes the air out of gold, even as it creates jobs that stoke profit growth and increasing wealth via rising equity prices).  Any one or two of the three conditions being met in isolation (which often, in fact, occurs) is by definition not stable or sustainable with respect to achieving and maintaining prosperity.   Absent a Eurozone financial markets blow-up and banking crisis, and assuming no war with Iran in 2012 (both assumptions, we concede, are less certain than when we made them a month ago), the U.S. economy is poised to show a decent year in terms of GDP growth and a gain in equities.  But investors should hardly be quiescent about all three of Mr. Calhoun’s conditions being met in the near term: the political class has continued to neglect urgent fiscal reforms and, if we can borrow a colloquialism, has trashed the U.S. dollar now for a decade.  This was the same dual-headed policy-error monster that led us into the 1974-1982 torpor referenced above, and amounted to nearly a lost decade for growth and spread of U.S. prosperity.

Mr. Bernanke has, as we say, been too clever by half in that he seems not to care about the dollar’s value, and feels he can reverse the Fed’s balance sheet growth at times of his choosing moving forward.  But he has also now stated monetary and price stability is less important to him than employment growth, and indeed he may well be setting up the conflicting policy aims that ensure his unleashing inflation in the U.S. economy.  For the fact is, there is no easy way to shrink the Fed’s balance sheet without inducing higher rates and a 70’s-style price spiral at the same time.  While in theory the money supply decrease will keep prices level, in fact, as per the ’70s and early ’80s, it will happen with a lag, and this time the foreign dollar redemptions will be more severe.  We think 2012 may well be in the 3-4% range for consumer price inflation, but fear an extended period of higher interest rates and 5-7% inflation (or higher still?) in the years ahead.  Inflation, remember, also has self-reinforcing propagation mechanisms once unleashed: consumers and corporate investors come to hear prices will be higher tomorrow, so they will want to buy today.  At first that may indeed increase the level of real activity, but in time it comes to represent nominal increases, in prices only.

Again, our best guess — and it is no more than that even though we state it with some confidence — is that 2012 will see another year of mild inflation that we nonetheless think might be north of 2011.  But this situation needs to be monitored closely over time here this year, via the high-frequency data that is reported weekly, as well as Fed balance sheet moves (which, we still worry, may well include a round of QE3, given Mr. Bernanke’s morbid fears about Europe and long term clamps on U.S. investor sentiment).  If conditions begin to evince a new era of rising prices, investors will seek to move to traditional havens including commodities, precious metals, and natural resource stocks, along with foreign assets and currencies.

Can the tragedy of 1974-82 be avoided?  Four years into an economic disaster created by the political class, the sure answer is, of course it can.  But for this to happen, better policies will be needed from Washington:  basic laws of sound economics must no longer be ignored, as Mises warned above, and sound money must once again become the cornerstone of pro-growth (that is to say, pro-capital investment) economic policy.  And this in turn implies that the temptation Keynes alluded to — unlimited borrowing and fiscal profligacy at the zero-bound for interest rates, which is in effect where we are now — must be resisted.  To say this differently, Keynes was describing (in his 1936 book) what he thought was a purely theoretical situation that even he conceded could end in an insane level of profligate spending.  Sadly, in the current era in Washington, D.C., life has come to imitate a long-ago theoretical conjecture even as it affirms the wise warnings of a great economist delivered through the mists of time.  Sorrowful history, sadly, only repeats itself when such warnings are ignored, in this case by an unrepentant and indeed arrogant political class, but it need not be so if Calhoun’s Golden Rule becomes the de facto policy target.

For information on Alhambra Investment Partners’ money management services and global portfolio approach to capital preservation, John Chapman can be reached at john.chapman@4kb.d43.myftpupload.com.  The views expressed here are solely those of the author, and do not necessarily reflect that of colleagues at Alhambra Partners or any of its affiliates.  

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