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Today's Market WrapUp  07.30.2003  Mon  Tue  Wed  Thu  Fri  Puplava Archive

Inflation By Any Other Name
BY JAMES J. PUPLAVA, CFP

I got into this business over 24 years ago after spending 4 years in public accounting and corporate life. When I started my career in the investment business, it was a lot different than where it is today. Back then nobody had any confidence in government or its paper. It was a terrible time to be holding paper assets. The inflation rate was in the double-digit range, interest rates were in the mid-teens reflecting inflation worries and the stock market had gone virtually nowhere after peaking in 1966.

The 1970s was a period that became an extended bear market for paper assets. Stocks performed horribly and bonds continued to lose money each year for investors as inflation eroded their value. In the investment business, bonds were referred to as “certificates of confiscation.” Inflation continued to erode their value each year as the Fed furiously pumped new money and credit into the financial system. Economic growth was anemic despite government’s attempt at fiscal stimulus. The Fed was monetizing government debt. What the government couldn’t raise through taxes, it gained by printing money and depreciating the currency. Inflation was simply another means of taxation of exacting additional revenues out of the economy.

Despite attempts to inflate and stimulate the economy, economic growth was anemic and inflation remained high. Economists invented a new term to refer to the economy’s dismal performance and high inflation rates. This term was stagflation. Webster’s Dictionary defines stagflation as “an economic condition marked by a continuing inflation together with a decline in business activity and an increase in unemployment.” That is where we are today. We are coming full circle to where we were 24 years ago when I got into this business. As the following charts indicate, economic growth rates have remained anemic, the monetary spigot is running at full throttle (inflation) and the unemployment rate is rising. These are stagflation conditions.

I believe stagflation is why interest rates are now beginning to rise. The bond market is just waking up to the fact that it has been fooled by the Fed. Inflation is and always will be a monetary phenomenon. As along as the Fed expands credit or debt-based money into the economy or the financial system, we will always have inflation.

It Ain't Deflation

The greatest myth we have today is that of deflation. As long as the Fed exists as an institution with the ability to expand money and credit in the financial system and in the economy, we will have inflation surface somewhere. The confusion here is simply one of definition. American economists repeatedly err by sticking to an inflation definition that is confined to rising goods prices.

In other words, American economists only recognize inflation in terms of rising prices for consumer goods. They ignore the definition of inflation recognized by the Austrian school of economics and as defined by Webster’s Dictionary. Webster’s Dictionary defines inflation as “an increase in the amount of money and credit in relation to the supply of goods and services, an increase in the general price level, resulting from this, specifically, an excessive or persistent increase, causing a decline in purchasing power.” In this regard I would direct the reader to the charts below showing actual dollar growth in the money supply and the rate of change. The three month rate of change for M1 and M2 is growing at over 10% and at an 8% rate for M3. Over the last 12 months, the money supply has been growing and has been increasing for all three indexes. The rate of change for M3 has been in decline until recently reflecting a move out of money market funds by investors into other paper assets as a result of the decline in general interest rates.

Fed + Money Supply  = Debt --> Bubbles + Inflation Somewhere

As long as the Fed has the ability to expand money and credit within an economy and financial system, inflation will surface somewhere. What has happened over the last two decades is that the inflation created through the expansion of money and credit by the Fed has found an outlet in the financial system. The money created moved into paper assets—most notably the bond and stock markets—giving us a bull market in paper. The size of the debt markets has grown from under $1 trillion in 1980 to over $40 trillion today. The result is that all of this money and credit has turned America’s economy from an economy that produced real goods to a financial economy with large capital markets and large asset bubbles in stocks, bonds, mortgages and real estate. The only problem with this transition to a financial economy is that it has a tendency to create large asset bubbles as money moves through the financial system. This creates malinvestments in the economy as this credit money moves in and out of sectors leaving asset bubbles in its wake. This can be clearly seen in the oil patch in the early 80’s, the real estate market and S&L crisis at the end of the decade, the peso and derivative crisis in 1994, the Asian crisis in 1997, LTCM and the Russian debt crisis of 1998, Y2K in 1999, and then the recession and 9-11 crisis in 2001.

With the Greenspan Fed constantly fueling asset bubbles through its loose monetary policies, what we repeatedly get is one asset bubble following another. The stock market bubble burst in March of 2000, but it was immediately followed by a bubble in the bond market, mortgage market, housing market and consumer consumption. What is important to understand in a financial economy such as ours is that the Fed can print sufficiently large enough quantities of money and extend unlimited amounts of credit to keep deflation from occurring. The Fed—if it wants to—could bail out any troubled financial institution or market through its monetization of debt to keep that market from deflating. In reading recent Fed speeches and research reports, it now appears that this is becoming official policy. A recent research paper by the Dallas Fed in May of this year outlines future Fed policy options to avoid deflation. They are as follows:

1)   Implement a carry tax on holding cash of up to 1% per month.

2)   Purchase of assets; foreign currencies, real goods and services, long-term Treasuries and other financial assets such as corporate bonds, commercial paper, equities, and mortgages.

It is clear from research papers dating back to 1999, 2001, this year and recent FOMC meetings that the Fed is considering and weighing its options as the asset bubbles it created border on collapsing. (See our FedWatch for pertinent articles.) In this regard it has already set the stage to bail out large financial entities such as Freddie Mac and Fannie Mae if need be. An example of this kind of policy can be viewed in China where the central bank keeps state-owned enterprises alive through credit. It comes as no surprise that inflation is rising once again in China.

A Time for Truth & Consequences?

The only problem with this approach to monetary policy is that it brings with it consequences—most notably a depreciation of a nation’s currency. The dollar has already begun to erode against other currencies as viewed in the graph of the dollar below.

The first stage of a currency debasement is usually against other currencies. However, since most governments and central banks will respond in kind by depreciating their own respective currencies, the next stage in this development is the dollar’s gradual, then accelerating depreciation against gold, silver, commodities and other hard assets. At the moment Asian central banks are attempting to neutralize the dollar’s fall against their own currencies through intervention in our bond and currency markets. They do this by buying Treasuries in an attempt to keep their own currencies from appreciating against the dollar.

History has shown us that in every circumstance when a king, emperor, government or central bank pursues policies of debasing the currency through excess money creation, the problems within the economy are aggravated eventually leading to its collapse. Currently all that the Fed has been able to do is create new bubbles in the economy through the mortgage and real estate market and in the financial system by creating a stock and bond market bubble. The excess money creation has led to some signs of inflation, most notably in housing and in services. The most visible signs of inflation are in the bond and stock markets. The stock market partially deflated from 2000-2002. The bond market is now in the process of deflating as bond and foreign exchange markets begin to wake up to the fact that they have been fooled. As the inflationary polices of the Greenspan Fed and other central banks under its control continue to ratchet up in high gear, we are headed not only for higher inflation, but a series of currency crises beginning with the dollar that can lead only to its demise.

Paper Holders: Caveat Emptor

That monetary reflation is heading into overdrive is visible not only by the recent acceleration in the rate of change in money aggregates over the last three months, but also by the rhetoric of Fed officials. Several weeks ago Greenspan told Congress that economic growth would accelerate to 3.5% in the second half of the year, and then accelerate to the 4.75-5% level by next year. The only strong sector in the economy over the last few years has been the housing market and consumer consumption. With consumer confidence falling dramatically and the refi market slowing down along with new mortgage applications (refinancing plummeted 32.9% in the week ending July 25^th and new loan applications to buy new homes fell 3.5%), I wonder what sector will emerge to give us the kind of growth the Fed keeps predicting. An economy the size of the U.S. at $10 trillion growing at 5% a year is a sizable achievement. To get the economy to grow at this rate means that major monetary inflation is about to take place. This may be what the rise in gold, the rise in interest rates, and the fall of the dollar may be signaling. The Fed may be embarking on a policy of hyperinflation if left unchecked by the financial markets. To owners of paper assets, caveat emptor. Your holdings of paper assets, be they bonds, stocks or cash, is about to be made worthless. I believe we will begin to see hard assets such as silver and gold, energy and other hard goods begin to rise at rates that are commensurate with the Fed’s ability to inflate.

Given the Fed’s intention—publicized openly—to inflate away the currency, investors would be wise to take refuge in the only durable and real currency of choice throughout all of history: silver and gold. It is the only money that isn’t someone else’s liability. It can’t be destroyed or inflated away.

Additional Economic Charts of Interest

Today's Market

Stocks narrowly edged lower with losses in the Dow for the third consecutive trading session. Investors remain cautious ahead of this week’s big economic reports due out tomorrow and on Friday with the unemployment report. Economists and analysts were stunned yesterday by the big drop in consumer confidence. Ahead this week is an advanced look at Q2 GDP, the Institute of Supply Management report on manufacturing, and Friday’s employment report. Now that the Q2 earnings season is coming to a close, analysts and investors are turning their attention to the economy for signs of the widely forecasted second-half recovery.

It appears that Fed officials may now be paying attention to the bond market as bond prices rallied today as the government tapped the bond markets with plans to sell $60 billion in 3, 5, and 10 year notes. Bond prices got a lift through the Fed’s Open Mouth Committee with Fed Governor Bob McTeer. Appearing on CNBC’s “Squawk Box” this morning, the Fed governor said thanks to Fed policy we can have it all, low inflation, low interest rates and high economic growth due to excess capacity and unemployment in the system. The Fed governor said the Fed is willing to keep interest rates exceptionally low in order to see the economy improve. Even though the Fed is forecasting high growth rates of 5% for the economy next year, it won’t create inflationary pressure because of a slack labor market and excess capacity. The hitch in this forecast is that the predictions in the Fed’s own words are “based a lot on faith and very little on actually seeing it yet.” McTeer cited the rise in interest rates as a clear sign that the bond market is predicting higher growth ahead for the economy. An alternate view to rising bond yields could be that the bond market is no longer buying the deflation story anymore.

Also weighing in on the markets today were comments from Intel’s chief executive Craig Barrett, who said that spending on technology will be little changed this year. This suggests that earnings for computer-related companies will fall short of forecast during the second half of the year. This is nothing new for anyone following what companies have been saying all along since the beginning of the year.

Expect volatile markets for the rest of the week as important economic numbers are released by government and industry. Economists are predicting that the unemployment rate dropped last month to 6.3% and that the economy will have created 10,000 hypothetical jobs. Nobody will know where these jobs have come from since they are statistically and seasonally adjusted. If you have lost your job, you may now be out of season, statistically, and not included in Friday’s unemployment number. The government keeps changing the way it measures and accounts for unemployment. It has magically been able to make unemployed workers disappear to become gainfully employed at statistical firms in heaven. Meanwhile, Pillowtex filed for bankruptcy today announcing it was letting go of 6,450 workers. TeleTech will let go of 400 workers and close down its service center. May Department Stores said on Wednesday that it plans to divest 32 Lord & Taylor stores and take a $380 million charge.

Volume came in at 1.36 billion shares on the NYSE and 1.51 billion on the NASDAQ. Market breadth was negative on both exchanges by 17-15 on the Big Board and by 17-14 on the NASDAQ. The VIX rose .49 to 20.72 and the VXN added .70 points to finish the session at 30.86.

Copyright © 2003 Jim Puplava
July 30, 2003

Graphic Source: "U.S. Economy and Financial Markets" New York Federal Reserve (pdf)

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