Whole Lot of 'Flation Going on...
Despite rumors to the contrary, the Fed tells us, inflation is no threat, and deflation is no problem. "And yet," Bill Bonner points out below, "there must be some kind of ‘flation somewhere…"
Something awful is afoot, we think. But what?
In almost every direction we look, we see people going about their business as if nothing were wrong. And yet, they say and do such strange things.
One of the things that makes us feel like a very minor character in a very bad movie is the Fed’s "emergency" 1% lending rate. Fed governors admit to no emergency. There is nothing to worry about, they say so often it makes us wonder. Inflation is no threat. Deflation is no problem. And yet, there must be some kind of ‘flation somewhere. Why else would the Fed allow the money supply (M3) to increase at the astounding rate of $1 trillion per year?
And why else would it lend money at less than the quoted rate at which it loses value? The CPI rose 1.7% last year – even by the government’s own, fishy way of calculating it. Even in the best of circumstances, the Fed could not hope to get its money back…that is, unless things went really bad…and inflation sunk below zero.
But this week brought news that inflation was headed in the opposite direction. Last month saw a .5% increase in consumer prices. Annualized, inflation is running at about 6 times the fed funds rate.
Predicting Inflation: Thinking You Know Everything
"Specter of inflation reappears in the U.S.," warned the International Herald Tribune yesterday:
"’We are nearing the end of a benign, unusual period of faster growth and lower inflation and moving into a period of slower growth and higher inflation,’ said John Makin, resident scholar at the American Enterprise Institute in Washington."
How Mr. Makin knows these things is anyone’s guess. After repeated, embarrassing efforts here at the Daily Reckoning, we have given up pretending that we know anything at all, let alone anything about the future. But the folks at the American Enterprise Institute have flated out their opinions as if they were facts; in the gassy world of 2004, they think they know everything – or everything they need to know.
Mr. Makin might be right about the direction of inflation. Then again, he might not. One guess is as good as another. There’s nothing unusual about people claiming to know what they cannot. The editorial pages are full of such pretenders. What is extraordinary is that they are so confident about their claims. On the basis of a guess, they are willing to do things that in the past have almost always turned out to be ruinous.
The Fed’s 1% lending rate is a curiosity. It is extremely rare; a normal, sentient homo sapiens sapiens would consider it a mistake to bet the farm on it.
Predicting Inflation: The Extraordinary 1%
But that is what people do. On the advice of the nation’s leading mortgage advisor, Alan ‘Bubbles’ Greenspan, they refinance their homes at adjustable rates. Maybe rates will go up…maybe they won’t. Our only point is that 1% is extraordinary, and it takes an extraordinarily confident investor to believe that extraordinary circumstances will last forever.
A chart of short-term rates in Grant’s Interest Rate Observer shows how extraordinary 1% is. Looking back to 1831, a 1% rate has been reached only two times – first in the 1930s…and again now. There is something unnatural about it, we conclude; it only happens when there is a crisis on the scale of the Great Depression. Surely, some crisis must be at hand, or afoot. But what?
Looking casually at the chart, one sees that that short-term rates are usually around 5% – except in periods of crisis or inflation, when they can spike up as high as 35%, as they did in the Panic of 1837.
Another thing you notice is that the pattern of short rates after the establishment of the Federal Reserve in 1913 is very different from the pattern pre-Fed. Before the Fed came into being, lenders must have expected to get back money of about the same value as the money they lent. There was no upward slope to the yield curve. In fact, rates more often tended to go down as the length of the loan increased.
Investors who lent long-term during and after the depression…and right up to 1981…lost money. They lost much more money than stock market investors in the crash of ’29 or, relatively, in the still-unfinished bear market of 2000-2002. Anyone who had offered a 30-year mortgage, for example, in the early ’70s at 6% was practically wiped out a few years later by inflation. By 1981, short rates had risen to 16.3%. Long bonds and long mortgages, bought a few years earlier, were the subject of ridicule.
Money was made by investors who lent at 16% in 1981. That too, was an extraordinary year…and hasn’t been repeated since. Instead, rates went down for the next 22 years. At 16%, lenders had a lot to look forward to – high yields and capital gains, too. At 1%, there is little room on the downside for rates and little upside left for lenders.
At today’s rates, a person lending for 30 years is making an extraordinary gamble. The lending rate is lower than last month’s inflation figure, annualized. If nothing changes, the reward he will get for letting out his money until 2034 will be substantially less than nothing. Who would take such a bet? Who would make a guess about something so far in the future and then stake his money on it? Only someone whose judgment has been flated by the heady vapors of the present.
Still, the wicked thing coming our way could take rates lower…as happened in America in the ’30s…and as happened in Japan in the ’90s…and leave them there for a long time.
Predicting Inflation: Inflation May Dally
The inflation people think they see coming could dally a long time before showing up.
"Inflation looks to be next import from China," the International Herald Tribune follows up its inflation story today. China, growing at 9% per year, is gobbling up the world’s resources and primary products – steel and oil, notably.
The people who think they know what direction inflation will take also think they know what direction China’s economy will take. They could be right. Or, they could be wrong.
A letter to a colleague suggests that China’s booming growth could come to a halt tomorrow:
"I have been a resident of Tokyo since 1989 and although I’m not personally involved in business here, I teach at a college, I think you may be interested in my experiences as I lived through the tail end of Japan’s bubble economy and of course through the prolonged decline.
"Firstly I’d like to compare Tokyo in ’89 with Shanghai in ’03. On a visit to Shanghai last year the atmosphere felt curiously similar to how Tokyo felt in its bubble. This is a purely subjective opinion I hasten to add, but the air of optimism bordering on invincibility is almost exactly the same. I noticed a similar feeling in Thailand in ’96-’97, where previously helpful people treated the passing tourist with disdain.
"To return to Shanghai the trip from the airport to downtown has to be seen to be believed. The levels of construction projects are truly outrageous. To reiterate, this is purely a subjective opinion, but I sold all my Chinese investments shortly after returning, as the parallels to what I had witnessed in Tokyo were to me ominous."
Now, we have nearly come back to where we began in the 1930s – with short rates near zero. If we were guessing, we would guess that the downwards trend still has a way to go.
Today’s ebullient world could collapse in a heap. China could blow up. The shortage of primary commodities could quickly turn into a glut. The Fed could cut rates, rather than hike them.
We don’t know. But at least we know it.
The Daily Reckoning
April 16, 2004
P.S. The American Enterprise Institute must aspire to divinity. Its scholars claim to know things that mortals never could know before. Not merely the future of inflation rates…but the future of the entire world. The ‘think tank’ thinkers think they can read not only tomorrow’s headlines, but those a half-century ahead. In a remarkable work, Charles Krauthammer tells us:
"At the dawn of the twenty-first century, we can see clearly the two great geopolitical challenges on the horizon: the inexorable rise of China and the coming demographic collapse of Europe, both of which will irrevocably disequilibrate the international system. But those problems come later. They are for mid-century. They are for the next generation. And that generation will not even get to these problems unless we first deal with our problem. And our problem is 9/11 and the roots of Arab-Islamic nihilism."
Mr. Krauthammer may have views on the fed funds rate in 2054, too. We don’t know. He is entitled to believe any goofy thing he wants. And if he wants to bet his own money on his guesswork, so much the better. But what is really remarkable about today’s ‘flationary period is that people not only believe they can look into the future, but they are also so sure they can get what they expect, they are perfectly willing to kill people to make sure.
Editor’s note: Bill Bonner is the founder and editor of The Daily Reckoning. He is also the author, with Addison Wiggin, of the international bestseller: Financial Reckoning Day: Surviving The Soft Depression of The 21st Century (John Wiley & Sons).
Today, we leave the news to Addison. We are en route to Venice, where we will spend a week on vacation. But we had time to pen you an essay on the way, dear reader, which you will find below.
In the meantime, we cede the floor to our Baltimore-based colleague:
Addison Wiggin, writing from Baltimore…
– In 1982, the yield on the 10-year U.S. Treasury bond peaked at 14.95%. On June 3rd, 2003 – 21 years later – the same bond yielded 3.07%.
– "What caused the bull market in bonds?" Your Baltimore editor was quizzing his motley team of economic advisors this morning. The question might appear rhetorical – as if he already knew the obvious answer – but it wasn’t. Instead, he was hoping someone else might have an epiphany. "Supply and demand?" came a tentative reply.
– The world is certainly bloated with bonds. Logically, in order for bond prices to rise, demand must gobble up their available supply and still ask for more – which certainly doesn’t trouble the money-hounds at the Treasury. As bond prices rise, yields fall…but therein lies the question: what on earth happened to push yields all the way from 14.95% to 3.07% in just 21 years?
– The answer can be split into two parts: 14.95% to 6% and 6% to 3.07%. Why 6%? First, it’s a nice round number at one end of a "normal" interest rate spectrum (look in your old economics textbooks and see what interest rate they used in the examples)…and second, 6% was the approximate level of ten-year T-Bond rates when the "tech bubble" burst and the real monetary mayhem began.
– The American "economic miracle" turned heads the world over. The U.S.’s power economy – which was, of course, a credit-goosed sham – was the envy of the money world. Capital poured in from overseas as investors looked for a piece of the action. After all, a 6% virtually risk-free return in T-Bonds was low, but not that low. At the time, inflation and dividends were equally insignificant…and the dollar was still rising.
– But as the bond bull powered ahead, pressing yields to even greater depths of absurdity, new and imaginative reasons were required to part fools from their money. Enter the heroes at the Central Bank, with a pocketful of so-called ‘solutions.’
– The infamous "Greenspan Put" – the Fed’s implicit guarantee of low rates – helped crank up yields to the highest heights of idiocy. Astute carry traders knew what to do…they borrowed cheap money from the government at 1%, then lent it straight back, at 5%, 4% or even 3%, somewhere further down the curve. The absolute yield levels, as insanely low as they were, were irrelevant. The sun was shining, and bond traders made hay – bales and bales of it.
– The wheeler-dealers in power in Japan and China had their fingers in the pie, too. Depending on the almighty American consumer to purchase their products, Asian central bankers decided they did not want to see their best customers impoverished – as an all-out dollar rout would certainly render them. So, in a bizarre vendor-financing scheme, Japan and China traded trillions of yen and renminbi for U.S. dollars…with no regard whatsoever for the yield on their investments.
– And so we return to our original question…and stumble towards a conclusion. What caused the bond bull? We can’t help but notice that the terrific run-up in bond prices didn’t quite make sense. Bond investors, both of the individual and the central bank variety, were not driven by the yields they hoped to earn. Instead, they were motivated by circumstance.
– This week, those circumstances appear to be a-changing. Japan is growing, and China is overheating – apparently reducing their urge to prop up the dollar. In America, inflation, earnings and jobs are widely construed to be "improving"…though we cannot help but wonder at improving’s novel definition. As the U.S. economy warms up, Greenspan will have to back off the "emergency" 1% rate, the lumpen say to themselves, scrambling to drop their bond holdings.
– Will Greenspan raise the fed funds rate? Yes. When? We haven’t the foggiest (more on this from your Paris editor, below…). But the Greenspan Put’s expiration date may be at hand…and it seems that Asian Central banks may be about to give up meddling with exchange rates. With these distortions removed, the market will be free once again to focus on yield.
– What will ensue is anyone’s guess. Imagine the U.S. dollar as a circus tiger that is sent to Africa to live on the savannah. Suddenly, the hitherto-pampered show tiger must compete for its dinner against his wild cousins…who are much leaner, meaner and stronger. In the same way, the poor buck must compete against currencies paying four or five times as much interest.
– Mr. Market continued to react perversely to the news yesterday – sizing it up and then running away. The Nasdaq lost 22 points on strong earnings from Texas Instruments, Apple and Advanced Micro Devices. The final score lay just north of 2,000 (2000 was briefly pierced). The Dow and S&P had hardly budged by the close. The funny yellow metal lost another two dollars, while silver managed to find a foothold at $7, and added 7 cents to close at $7.07.
– As a closing thought, last summer, 10-year bond yields moved from 3.07% to 4.67% in 8 weeks – a record 160-basis-point move – while in exactly the same period, the interest-sensitive Dow Jones REIT index GAINED 1.4%.
– In the last 30 days, yields have moved from 3.65% to 4.4%, a mere 75 basis point rally. Meanwhile, the torpid REIT index has DROPPED 14% over the same period. There is a lesson here somewhere. If anyone can find it, please contact Addison.