Inflation Or Deflation?

Japan has seen it all. Stocks crashing for a decade. Unemployment rising. Billions in stimulus with no effect. Rates cut to zero.

What the Japanese have not seen is the very thing you might expect when you give away money: inflation.

Instead, prices have fallen. Consumer prices have been falling at annual rate of 2%, and asset prices – both real estate and stocks – have collapsed to a third to a fifth of their previous levels.

Here again, without hardly trying, the Japanese may have become trendsetters.

American investors, yesterday, looked as far into the future as they could. What they could see, we don’t know. But we know what they didn’t see: inflation.

Bonds hate inflation. At the sight of inflation on the far horizon, bonds fall in price…and yields (the return per unit of capital invested)…jump. Yesterday, the yield on a 10-year T-note didn’t jump. It sank…to 4.46%. Meanwhile TIPS, bonds with inflation protection built in, were paying 3.08%…a mere 0.37 % above the current inflation rate…and only 1.38% less than you can get from the non-protected note. This differential is a rough measure of what investors expect from inflation. It has reached a new, very curious low level.

It is new because never before have investors estimated the rate of inflation over the next ten years at such a low level – 1.38%. It is curious because never at any time in the last 3 decades has the inflation rate been anywhere near that low. Instead, it has averaged 1.9% for the last 30 years and now stands at 2.7%.

Investors are betting that inflation will decline to half the current rate…and stay at a level it hasn’t seen since the Nixon administration.

Investors – perhaps the same investors who saw no risk of a bear market – now see no risk of inflation. Indeed, inflation seems as remote a risk today as an attack on the WTC was in August, a risk – at the time – so slight that owners thought it unnecessary to fully insure themselves.

This is doubly curious, because never – since perhaps the Vietnam War – have governments shown themselves so eager to do what they do best…destroy their own currencies. And never, ever…as far as we know…has a war failed to produce a substantial increase in domestic prices.

“War is Keynesian,” writes Gary North. It is always financed by deficit spending and monetary inflation. Conservatives yell and scream that they want more freedom, but when war clouds or recession clouds roll in, conservatives join the Establishment’s Amen chorus for more government, more restrictions on liberty, and more inflation.”

The same people who once believed a peace dividend was good for the economy now believe a war will be even better. Those who urged Japan to build bridges to stimulate its economy seem to believe that destroying bridges will be just as good.

And where once they looked with pride on a budget surplus and a social security lock-box, they now cast their eyes appreciatively upon deficits and an open Congressional checkbook. If the taxpayers won’t spend their own money, they reason, government will spend it for them…

And those who never saw an economic downturn or bear market approaching…now see them going away, thanks to all this stimulus provided by the Fed and Congress.

Even in this post-irony age, we feel a great paradox coming on. Like the onset of the flu…it is but a chill…a mere, expectant frisson now. But soon, it may have us shaking feverishly and begging for relief.

Wars may be lost or may be won…either way, if enough stimulating firepower is used, a nation’s currency always seems to be among the casualties.

Here at the Daily Reckoning we are agnostic on inflation. We have little doubt that eventually the dollar will go the way of the austral, the confederate dollar, the sou, the livre, the reichsmark, the wara, stamp scrip, the Old Franc, the continental, the ostmark and every other paper currency ever created.

All things, paper currencies included, eventually regress to their intrinsic value. The dollar will be no exception. It has lost 95% of its value since the Federal Reserve was set up to protect it. Sooner or later, the Fed will succeed in eliminating the last 5%…

But, we also note that Japan has been unable to kindle inflation – despite all its efforts. And we suspect that Mr. Market will have some surprises for us first.

In America, people are on the hook for more debt than at any time in history. We suspect they will twist and turn a little…like the Japanese…before they are let off by inflation.

Bill Bonner
October 5, 2001

P.S. But I promised that today’s letter would be about gold. And so it is.

“Gold thrives on uncertainty,” observes an article from the BBC. “And the world has shifted into a new climate of insecurity. Risks have increased markedly. The attacks on the United States were the start of the drama, not the climax.”

Andy Smith, precious metals analyst at Mitsui Securities in London, and no gold bug, believes the yellow metal “could go to $340 an ounce within the next three months…and continue to soar after that.”

Maybe. Maybe not.

But in a world of full of risk, a little bit of insurance seems a healthy precaution. Gold, at $289, seems cheap protection.

Barron’s “value picks” became slightly better values yesterday. GE, for example, fell 2%. Fannie Mae dropped 1%.

But who cares?

Stocks are priced – according to the Wall Street Journal’s reconstituted numbers – at 36 times earnings. Whether they are going up or down doesn’t matter. They are far too expensive for a sensible investor. The rule in investing is to buy low and sell high. If you buy high, instead…it won’t work (unless you are lucky enough to sell to an even greater fool.)

But what if you are holding stocks? People don’t seem to mind holding stocks at prices they would never buy them. But it is the same thing…you are either long a stock or you are short. The middle ground is an illusion…

If a $100 stock goes to $50…it doesn’t matter whether you bought it yesterday or 10 years ago…the loss is the same.

Of course, many people believe that the huge losses in the stock market have not really hurt investors…yet. Because the stocks were bought years earlier at even lower prices. The losses, they argue, have been mostly “paper losses.” But this market is now at levels not seen since the end of ’98. Anyone who invested money after that date is facing a real loss, not just a paper one.

Those who invested prior to the end of ’98 have made no money, collectively, in stocks for the last 3 years.

Eric…over to you…


Mr. Eric Fry, in the land of milk n’ honey:

– The stock market was open for business yesterday, but there was no real good reason to show up. Stocks thrashed around all day and by the time trading ended, the Dow was down a little and the Nasdaq was up a little.

– Without Alan Greenspan cutting interest rates or President Bush stopping by, what chance did the stock market have of putting on a big rally?

– But just because the Fed Chairman took the day off doesn’t mean he won’t be cutting rates again soon. “What is clear is that in monetary matters, there will be no erring on the side of stringency,” writes Caroline Baum of Bloomberg News. “The inflation-adjusted federal funds rate is now -0.2 percent. In other words, banks can get free money from the Fed and, thanks to the steep yield curve, lend it out or buy Treasury securities for a nice profit.”

– Yet, despite Greenspan’s monetary largesse, inflation is on the minds of almost no one these days. “CPI inflation has slowed around the world, and based on the significant global slowdown in economic activity, it’s likely to slow even more,” predicts International Strategies & Investments.

– Maybe so. But if one feature of the investment landscape has changed since September 11th, it is that inflation is no longer an impossibility. The Bush Administration will be waging just as fierce a war against a slowing economy as it will be against the dark forces of terrorism. The early battles in the economic campaign feature deep interest rate cuts (so far, nine cuts in little more than nine months) and an exploding money supply.

– What’s more, defense spending is on the rise, and not just temporary. “Arguably the U.S. may have under- invested in national security during the 1990s,” writes Moody’s John Lonski. “As a percent of real GDP, defense spending had dropped sharply from 1987’s latest peak of 7.4% to 2000’s 3.8%, which was the lowest such share since 1941, at least. Stepped-up spending on national security might curb productivity growth, where the latter would eventually add to inflation risks.”

– “Wartime is associated with…inflation,” observes Jim Grant in Grant’s Interest Observer. “Belligerent powers spend as necessary, borrowing to finance the inevitable shortfall in tax receipts…No Unites States war known to the research department of this publication has been waged in a deflationary setting.” (

– The trend makes Jim both bearish on the U.S. dollar and bullish on the inflation-indexed/protected Treasury Notes known as TIPS. “[Wartime spending] has, in the past, been inflationary, even in the gold-dollar era, which ended in 1971. Now, the dollar is [only] a unit of paper, convertible into nothing except small change. Yet so persistent is the deflationary undertow that the TIPS market, on the brink of war, is cheap.”

– Increased government spending in the form of rising defense payrolls, while somewhat helpful to the overall economy, is a poor substitute for private enterprise. “When government payrolls expand faster than private- sector employment,” Lonski writes, “some combination of slower productivity growth and more rapid wage gains have tended to emerge…When government employees rose from the 16.5% of non-farm payrolls of the 1960s to the 18.2% of the 1970s, the average annual rate of growth of unit labor costs shot up from the 2.1% of the 1960s to the 6.3% of the 1970s.”

– In support of Mr. Lonski’s argument I submit exhibit A: the post office and exhibit B: the DMV.

– From the glass half-full dept ISI predicts that the U.S. economy will recover in 2002. Among the reasons cited: G7 short rates, which tend to lead economic activity by 12 months, peaked in November 2000 and since then have declined a record 38% – from 4.75% to 2.95%. This has been a much sharper decline than the -6% over 10 months in 1990 or the -17% over 10 months in 1981/1982. And more easings around the world are in store (we expect a 2% Fed funds rate).

– Oil prices, which also tend to lead economic activity by 12 months, also peaked in November 2000 and have declined roughly -30% since then. Fiscal policy is already stimulative and is likely to become more so…federal spending, particularly defense related, is set to accelerate.


Back in Paris…

*** “Global Slump Could Last Until 2003” says an OECD report.

*** The outlook for Japan? “Dismal.” And in America? Job losses in September were up 77% over August…and 4 times those of the level a year ago. Recession is a “done deal.” And Warren Buffett predicts that it will be like a winter nap…longer and deeper than most people can imagine.

*** What’s more, the World Bank notes that the downturn in growth is likely to push thousands of very poor people over the brink. As many as 40,000 children under the age of 5 will die, it estimates.

*** But what is tragedy abroad is comedy at home. The forces of bullish illusions are infiltrating everywhere…apparently even in my own business.

*** An informer in Baltimore passed along this report: “Earlier today a Legg Mason rep. met with Agora employees to go over 401(k) investing strategies…his goal was to make us feel GOOD about investing… especially for the long term (as he defined as the next 3, 5, or 10 years). Here are some of his comments concerning today’s market:

“‘Today’s market is UNDERVALUED’…he said…’we are at historic lows…The market is drastically mispricing companies.’

“I didn’t want to be rude,” says my source. “But, I couldn’t let him lie like this…so I asked 1 simple question:

“I asked him how he could sit there and say our market is at a historic low, when the average P/E ratio on the S&P 500 is around 25 or 26…and the historic average is 11 or 12!

“His response: ‘That is a good question, and I have an answer. You see, today’s companies aren’t valued the same way as they were 50 years ago. Companies today are valued on cash flows…not simple price to earnings. (I don’t really know what that means…but I let him continue). You see, there weren’t growth companies back in the 40’s or 50’s like there are today. So, to say that a company with a P/E of 35 is overvalued compared to a company with a P/E of 8 (in the 1950’s) is absolutely untrue. He says using yesterday’s ratios in today’s market is not only impossible…but dead wrong!

“Here is his investing strategy NOW:




“One of the WORST things to do in today’s market, he said, is hold cash. Now is the time to fully invest in stocks…especially since they are at their ‘historic lows’!

“Here is a quote that I liked: ‘Today’s businesses aren’t going out of business. What we need to see is consumer confidence…we’ve reached the bottom! There’s no where left to go but up!”

“I had to laugh.”

The Daily Reckoning