With all due respects to our friends in Paris, let me say this: not only is the risk of a protracted Japan-style deflation overblown, but so too is the prospect of any significant disinflation from here. In other words, prices are likely to stay where they are, or go up…the latter being the more probable of the two scenarios.
The dreaded “D”-word made the headlines again recently after the Federal Open Market Committee tacked on a few extra words to its standard public announcement of its decision to keep short-term interest rates unchanged. In addition to the usual blather about the risks to economic growth, the FOMC added a shocking admission that it fears insufficient inflation. “The probability of an unwelcome substantial fall in inflation, though minor,” the FOMC’s announcement noted, “exceeds that of a pickup in inflation from its already low level.”
The pundits rushed to praise the Fed’s overtly pro-inflationary disposition. “Masterful,” said Goldman Sachs; “historic” and “profound,” gushed The Wall Street Journal. The layperson could surely be forgiven for not fully appreciating the moment. Did anyone really doubt that the Fed would maintain low interest rates, despite the lack of imminent inflation risk? The Journal, in more than one article, highlighted the irony that the same Fed whose mission it is to stop inflation now is apparently planning to aid and abet its rise. It seems a mind-blowing paradox…unless, that is, you know a little something about monetary history.
Deflation: Eager to Revive Inflation
Whether or not the Federal Reserve has a specific target rate in mind, it is hardly a secret that the Greenspan Fed is eager to revive inflation. Surely no one is expecting an actual contraction of the money supply. And while Japan and its seemingly endless travails always merit an obligatory mention whenever deflation comes up, few macroeconomic observers doubt that U.S. banks remain willing and able to create credit on top of the Fed’s already generous gift of base money. (For perspective, although slowing recently, the monetary base increased by an annualized 7.6% since late December.) In this context, it is hard to see where a sustained deflation might come from. The prospect of a few more cheap imports from China is not enough to support a convincing argument.
It’s true that that the prices of some goods and services have been falling, but that hardly means that we are living in a deflationary world. Most people seem to think that the CPI – or whichever index is favored at the moment – is the price level rather than a price level. But if you’re saddled with medical bills, or choking on the cost of college tuition, or digging deeper into your pocket to pay for a subway ride in New York City, then you’re probably wondering what all this talk of deflation is about. As long as your expenditures are not made up of exactly 5.961% for medical care, 17.293% for transportation, and 0.193% for infant and toddler apparel, then you’ve got your own personal CPI. Stripping out food and energy, as many economists are fond of doing, leaves the March inflation rate unchanged at 1.7%, year-over-year.
Overall CPI rose 3% in March and the more accurate measure of core inflation, the median CPI, increased 2.6% year- over-year. Obviously, it’s not quite time to stuff your cash in the mattress and reap the returns wrought by deflation. Even Pat Jackman, an economist at the Bureau of Labor Statistics, admits that the CPI Index may understate actual year-over-year price increases. The fact is, he told the Journal, “more money is coming out of your pocket.” And if the Fed’s reflationary mission succeeds, even more money will be coming out of our pockets.
Deflation: The Fed Will Find a Way.
Nor do we “worry” that the Fed will run out of ways to debase the currency. As for the problems awaiting the Fed once it hits the “zero bound” for short-term interest rates, there are probably much better things to worry about. If the Fed can’t use short-term rates to inject money into the economy, we are certain it will find another way. After all, Fed Governor Ben Bernanke brags that the Fed can “produce as many U.S. dollars as it wishes at essentially no cost.” These dollars won’t sit idly in bank vaults – we are clearly a long way from Japan and its malfunctioning banking sector, which has prevented the wonderful process of the money multiplier from taking hold in that beleaguered Asian nation.
No sir, no need to fret about deflation. We have all the confidence in the world that the Fed is willing and able to inflate. There are few sure things in finance, but the tendency of central banks to debase currencies is as close to a sure thing as the financial markets offer. Therefore, the market’s implicit forecast of a 1.7% CPI inflation rate over the next 10 years looks like a sure loser.
Fortunately, the remedy for investors is simple: sell long- dated, fixed-rate treasuries and buy the inflation-indexed variety, also known as TIPS. And while you’re at it, you might want to think about refinancing your home while the getting is good.
for the Daily Reckoning
May 14, 2003
What is going on in Japan?
Does anyone care?
After 13 years of bear markets, recession and deflation, most people think the Japanese are washed-up, financially incompetent has-beens, who can’t figure out how to work a printing press. For everyone knows the way to fight deflation is just to print more money! Even Milton Friedman says so. Why can’t the Japanese get the hang of it?
But here at the Daily Reckoning, we, and we alone, have long regarded the Japanese as trendsetters. With a population that is 10 years older…and a bubble economy that blew up 10 years earlier than our own…the Japanese have become fortune-tellers.
Which is why we noticed yesterday, when Eisuke Sakakibara spoke to the Financial Times: Deflation, said the man who knows more about it than perhaps any living human, is beyond the power of monetary authorities to prevent.
“Even if we don’t yet have [global] deflation, you have to concede that we have disinflation,” he said, attributing falling prices to rapid productivity gains in manufacturing, particularly in China. “Deflation is a structural, not a monetary phenomenon.”
“Alan Greenspan never used the word deflation,” he said, referring to the chairman of the U.S. Federal Reserve. “He called it an increase in productivity. But it’s the same thing.”
“In calling deflation structural,” continues the FT report, “Mr. Sakakibara is part of an increasingly vociferous intellectual movement that thinks Japan has been unfairly blamed for failing to tackle deflation with conventional monetary policy. The Bank of Japan, he said, had vastly increased money supply, but this had merely fuelled a bubble in the government bond market, in which interest rates on 10-year JGBs have dropped to 0.575 per cent. Credit had shrunk.
“Robert Feldman, chief economist at Morgan Stanley, has also argued that following classical monetary policy is inappropriate for Japan. ‘There’s something new going on out here and I would hope the economic theorists would be able to think about it without being poisoned by what they’re teaching their students,’ he said.”
American economists are still teaching their students that deflation is a monetary phenomenon…and it can be avoided by monetary means. “We have a technology…a printing press,” Ben Bernanke explained to the entire world. “And we can destroy the dollar any time we want,” he might have added.
Foreign dollar holders heard him loud and clear. Without waiting for Bernanke, they are destroying the dollar on international exchange markets. But US investors, economists, analysts, and wishful thinkers still believe that Bernanke’s printing press will keep them from following in Japan’s footsteps.
We will see…
Over to Eric Fry with the latest news from lower Manhattan:
Eric Fry in New York…
– Back in the days when investors worried about losing money, and when fear reigned supreme in the stock market, a coordinated terrorist attack against American interests in Saudi Arabia might have elicited a bit off consternation on Wall Street. But yesterday’s alarming headlines from Riyadh barely caused a ripple. The Dow eased a modest 47 points to 8,679, while the Nasdaq dipped 2 points to 1,540…
– Investors simply can’t be bothered with bearish news. But the grim news from Saudi Arabia did cause crude oil prices to jump more than one dollar to $28.42 a barrel. [Editor’s note: Outstanding Investments editor John Myers has long suggested Saudi Arabia is the real target for terrorists in the region…and has an interesting take on how this will play out in the price of oil.
– Remarkably, despite the surging oil price, Treasury bonds rallied for the fourth day in six, dropping the yield on the 10-year note to 3.62%. The stock market may be valued optimistically, but the bond market is priced for perfection, and we doubt that the world is as perfect as a 3.62% yield on a 10-year government bond would imply.
– Certainly, our balance of trade is far from perfect. America’s trade deficit in March swelled to $43.5 billion – – the second-highest reading on record. Apparently, the crumbling dollar has not had enough time to work its magic on our balance of trade. Maybe, if the Federal Reserve and Treasury can engineer another 20% dollar decline, we will have solved our global trade difficulties once and for all.
– It’s true that the stock market often climbs a “wall of worry”, but it is also true that the wall of worry can collapse at a moment’s notice, burying investors in the rubble of excessive optimism. The recent advance on Wall Street has been impressive. But that does not mean that a new bull market is underway. Since the Oct. 9 bear market lows, the Dow Jones Industrial Average has rallied 19%, while the Nasdaq has gained a sparkling 38%.
– “Does the sizable advance of the past seven months mark the final transition to a new bull market, or does it instead signal the beginning of the end for the advance?” wonders Adam Shell of USA Today. Although we do not possess a copy of next month’s Wall Street Journal, we suspect that the current rally is nearing its denouement, and will soon assume its place in financial history as the sixth bear market rally since the bubble burst in early 2000.
– “Since peaking in January 2000, the Dow has mustered up five big rallies with gains ranging from 15% to 29%,” Shell observes. “But they all proved to be short-lived, ultimately reversing course and resulting in new lows.” We are not predicting a repeat…exactly…but neither do we rule it out.
– During the months leading up to the Iraqi conflict, the lumpeninvestoriat had been retreating from the stock market and hunkering down in cash and bond funds. Investors pulled $27.7 billion from stock funds in 2002, and another $11.1 billion in the first quarter of this year, according to the Investment Company Institute.
– But the swift victory in Iraq unleashed a burst of optimism, which inspired investors to charge back into the stock market without regard for life or limb or personal retirement prospects. Only time will tell whether this “investor offensive” will come to resemble the brilliant “Chamberlain’s Charge” at the Battle of Gettysburg or the disastrous “Charge of the Light Brigade.” We wish America’s courageous investors well, even if we fear the worst.
– Bear market rallies – once underway – have a knack for converting terror-stricken investors into fearless speculators. All but the most timorous of investors begin to trust the rally and to expect large gains ahead. Case- in-point, Internet stocks are flying high once again. The “HHH” basket of Internet has soared a breathtaking 87% from its Oct. 7 bear market low.
– Even eminent skeptics like Morgan Stanley’s Barton Biggs have joined the bullish legions. “I continue to believe that this rally will carry further than most believe,” says Biggs. “My hunch is that it is not too late to play, because we may have traversed only half of it. The enthusiasm could grow. It’s the old story. After a long decline, for prices to rise the news doesn’t have to be good, much less great; it just has to be less bad than what has already been discounted…But make no mistake. It’s a rally in the aftermath of a secular bear market, not the beginning of a new bull market…yet.”
– Biggs is certainly right about one thing – the economic news has not been great lately, merely “less bad.” News that is “less bad” may be good enough to spark a bear market rally, but a new bull market will require bona fide GOOD news.
Bill Bonner, back in Paris…
*** Gold slipped back $1.30 yesterday. But June contracts are still above $350.
*** The Richmond Fed says that it looks like Tokyo or Yokahama around their neck of the woods. Manufacturing is down. Employment is still falling. Retails sales are weak, too.
*** Newsday reports that house prices in the Hamptons are falling.
*** Bonds hit new highs, with the long T-bond yielding just 4.62% and 10-year notes yielding 3.62%.
Why are bonds going up while the dollar goes down? Mr. Sakakibara explained, above, that this is what happens when the central bank tries to fight deflation by lowering interest rates: it creates a bubble in the bond market.
When will the bubble pop? We don’t know…
[And it’s worth noting that some investors and thinkers… some whom even we respect…our friend Jim Rogers and our colleagues in the New York office of the Daily Reckoning, for example…are not convinced that we’ll see deflation at all. On the contrary, the Fed’s attempts at debasing the currency will inevitably succeed, they say, and holders of the U.S. dollar will continue to suffer from declining purchasing power. See Andrew Kashdan’s comments below.]
*** Brigitte Bardot was on TV the night before last, fully dressed. Alas, she did not look like the same woman who appears in “And God Created Woman”…but that is the way of things. Forty years is a long time in the life of a sex symbol.
Bardot created a very popular sensation when she became the first actrice to take off all her clothes in a major movie. Now, she’s creating a sensation once again, by mouthing off on TV and in a new book with opinions that are not avant- garde, but retrograde. Bardot dislikes immigration, women in politics, homosexuals and any number of other things. Many, if not most, other French probably share her opinions; few dare to say so. One group is threatening her with a lawsuit for “inciting racism.”