inflation and stocks

wage inflation in the US?  …finally?

In my earlier post today, I didn’t mention that in the Employment Situation report from the Labor Department a week ago Friday, the annual rate of growth in wages rose from the 2.5% at which it had been stuck for a very long time, despite declining unemployment, to almost 3%.

an aside

Inflation in general is about prices in general increasing.  Deflation is when prices in general are actually falling.  Deflation is scarier than inflation both because it’s less common/harder to treat and because we have the object lesson of Japan, where a quarter-century of unchecked deflation has moved that country from penthouse to basement among world economic powers.

curing inflation

In developed countries, inflation is always about wages.

The garden variety, which seems to be what the Employment Situation may be signaling, is easy to cure.  …a little painful, but easy.

Raise interest rates.

The idea:  businesses want to expand.  To do that they need more workers.  But everyone is already employed somewhere.  So firms have to offer big wage boosts to poach workers from rivals.  Raising interest rates (eventually) stops that.  It increases the cost of expansion and also slows down demand.

Also nipping incipient inflation in the bud prevents consumer behavior from becoming all about defending oneself from it.

who wasn’t expecting this?

For years, economists have been anticipating a rise in inflation.  The first (false, then) alarms sounded maybe six years ago.

But, as they say, nothing is ever fully discounted until it happens.  In addition, Washington is arguably compounding the problem by enacting fiscal stimulus almost a decade too late–making it more likely that rates will go up sooner and more rapidly than if Washington had done nothing.  (Where did the deficit hawks disappear to?)

current Japanese inflation? ..there is none

Deflation means that prices in general are falling.  If this is the case, it’s better to put off buying new things for as long as possible, until they’re 100% absolutely needed.  That’s because anything you buy today will be cheaper tomorrow.

After a while, non-consumption becomes a habit, and an economy stagnates.

Conversely, in an inflationary environment, everything is more expensive tomorrow than it is today.  So consumers buy in advance.  In addition to things they need, they may also purchase items they have no intention of consuming.  They may think that keeping physical objects which they can later resell is a better way of preserving or enhancing purchasing power than keeping savings in the bank.

Japan has been in a deflationary economic funk for over a quarter century.   When Shinzo Abe became Prime Minister of Japan in late 2012, he decided to attack deflation as a way of boosting economic growth.  He had a plan that has become famous for its three “arrows”:  a massive depreciation of the yen, large-scale government deficit spending, and corporate/regulatory reform.  Each of the three should have been enough by itself to spark inflation.

The expense of the plan has been enormous, both in terms of the loss of international purchasing power of yen-denominated assets and in increased national debt.

The result after close to four years?   ….as the Tokyo government reported last week, no inflation at all.

How can this be?

From its outset, I’ve believed that Abenomics would be unsuccessful.  I thought the stumbling block would be corporate reform.  The earliest evidence that would indicate I would be wrong would, I thought/think, take the form of an effort to remove the legislative barriers to reform that the Liberal Democrats in the Diet had installed after the deflationary crisis had already begun.  So far, for all practical purposes there’s been nada.  So I continue to be convinced that corporate leaders will resist any changes to the status quo, aided as they are by the Diet’s removal of any levers to force reform from the outside.

Of course, any inflation-induced oomph to consumption won’t last forever.  People and institutions adjust. If nothing else, consumers run out of storage space for the extra stuff they’ve bought.  They then have to throttle back their spending   …or rent a storage unit  …or contemplate a McMansion.

What’s surprising to me, however, is that the same reluctance to spend–although perhaps not to the same degree–is evident in both the US and in Europe.  We might figure that the austerity approach of EU countries wouldn’t exactly spur consumers on.  But the lack of inflation and the paucity of mall-storming or website-crashing consumption in the US after eight years of extraordinary stimulus seem to argue that the overarching economic theories about how to induce inflation are incorrect.

Demographics as the cause?


keeping nominal GDP growth above zero

A reader asked a question about this after my Stephen King post from last Friday.  I think the best place for an answer is here.

In most circumstances, what counts is real GDP, not nominal.  That latter is, after all, just real GDP + inflation.  However, what comes to mind when people start to look for instances where nominal GDP shrinks is the Great Depression   …or maybe Japan during the series of Lost Decades it has been experiencing since 1990.

A potentially huge economic problem during a period of declining nominal GDP is that virtually all borrowing contracts–bonds or bank debt–are written in nominal terms.    In many places, labor contracts are also framed the same way, with an x% increase in wages yearly over the term of the agreement.

The revenues that businesses generate to meet these obligations are a function of unit volumes and price changes.  If real GDP is falling by, say, 3% and prices rising by only 1%, overall revenues are contracting.  Given that operating costs are typically fixed over the short term, this means firms in the aggregate will have less income to meet debt repayments and salary obligations.  For highly operationally or financially leveraged companies, even small declines in revenues can be deadly.

If, on the other hand, volumes are down by 3% and prices are rising by 4%, then revenue growth will still be positive.  On the margin, at least, this means fewer layoffs and fewer insolvencies to act as an economic drag during a time  when governments are trying to stimulate demand.


The situation where nominal prices are actually falling–which we’re not talking about here– is far worse.  Consumer soon learn that waiting a month, or two or three, before buying will mean a lower price.  So they just stop buying.  Given that consumers make up the bulk of economic growth in developed economies, they can ill afford to get the idea in consumers’ heads that purchasing anything today is a bad idea.

inflationary and deflationary mindsets

It’s fascinating to see how glibly and assuredly financial commentators and their guests have been talking about both inflation/deflation since the onset of the Great Recession.  What I keep thinking when I hear them is that to have practical experience of either phenomenon someone must either have lived in Japan or an emerging economy, or been an adult during the 1970s.  So most of these “experts” are just rehashing what they learned in a textbook.

What I think is important to consider about either inflation or deflation:

–what makes either dangerous is not simply that occasional spells of price rise/fall can happen.  It’s the possibility that people will begin to believe that inflation/deflation has become a permanent fact of life and alter their economic behavior to take this into account.  A mindset change, in other words.  Once that happens–and inflation/deflation is entrenched–it becomes extremely difficult to eradicate.  (In the inflation case, companies/consumers tend to favor hard assets over bonds or bank accounts, to consumer heavily and to avoid saving.  In deflation, they tend to hoard, underconsume and–again–favor hard assets like gold.)

–inflation and deflation are not mirror images of one another.  Historically, inflation has tended to spiral upward at ever-increasing velocity but can be cured by the monetary authority in a country boosting interest rates high into positive real territory.  Deflation, on the other hand, has tended to be a continuous downward grind.  Positive interest rates make borrowing a crushing burden.  The cure requires slower-to-act, less-likely-to-be-done fiscal stimulation or structural economic reform.

–in advanced economies, inflation and deflation are all about changes in wages.

–Japan is the current deflation poster child.  Its economic experience over the past quarter-century is the main reason, I think, that the word “deflation” strikes so much fear into global investors’ hearts.  Japan has recently devalued its currency by almost half in a so far vain attempt to get wages to rise.  In fact, real incomes for ordinary citizens have declined, because the local currency price of imported commodities like food and fuel has risen while wages have been relatively flat.

Japan is unusual in two ways, however:

—-the population is significantly older than in the EU or the US.  The local workforce has been declining for many years because of retirements; the country is strongly opposed to immigration.

—-resistance to structural change of any sort, and particularly change led by foreigners, is extremely strong.  As far as I can see, Japanese industrial technology is stuck back in the 1980s, maybe for this cultural reason.

It’s possible, therefore, that Japan’s current woes are more a function of an aging, hidebound population than anything else.  If so, then generic treatment of deflation–monetary and fiscal expansion–isn’t going to have much of an effect.  Unfortunately for the EU, “aging, hidebound” also sounds an awful lot like Europe.  So the EU may be next in line for the lost-decade syndrome.

Two other caveats:

–historical instances of inflation and deflation in the US have come during times when fixed-interest-rate bank lending was the norm for raising debt finance.  A changing price level could alter the real cost of that debt significantly.  This is no longer the case.

–indexing of wages and prices was common in the US during the 1970s and could easily have acted as a transmission mechanism for inflation.  Again, this is no longer the case.

my bottom line

I think the current economic situation is a lot more complex than pundits are making it out to be.  I also think they’re making a fundamental mistake by failing to distinguish between transitory inflationary/deflationary influences, like commodity price changes, and more fundamental, mindset-changing ones.  My guess is that this is because they’ve only read about the phenomena in books.






S&P downgrades Japan: a cautionary tale?

the S&P downgrade

Last week Standard & Poors downgraded the sovereign debt of Japan, reducing its rating on the Tokyo government’s bonds by one notch, to AA- from AA.  In doing so, S&P cited:

–high government debt ratios

–persistent deflation

–an aging population and shrinking workforce

–social security expenses at almost a third of the government budget, and rising

–the lack of a coherent plan to address the growing debt problem, and

–the global recession, which has worsened the situation.

With the possible exception of the last point, none of this is exactly news.  S&P could have cited all the other factors five years–or even ten years–ago.

What’s going on?

Two things, in my opinion:

1.  The Liberal Democratic Party, the dominant force in Japanese politics for the past fifty years, was tossed out of office in a landslide victory for the opposition Democratic Party of Japan in August 2009.  This happened once before, in the late 1980s, when the Socialist Party, from which the DPJ springs, did the same thing.  On both occasions, the transfer of power was followed by heavy-duty partisan infighting within the winning party, stunning ministerial ineptitude and legislative paralysis.  The past eighteen months have demonstrated that chances of another charismatic leader like Prime Minister Koizumi of the LDP emerging from the current fray are pretty remote.

2.  There’s a business cycle pattern to changes in the credit agencies’ ratings.  While the globe is expanding, the agencies’ ratings lag the economic reality.  They end up being too bullish for way too long.  In contrast, after having been castigated by the regulatory authorities and the markets for this behavior, the agencies become excessively cautious.  They downgrade aggressively and actively search for high-profile instances to do so, in order to tout their new-found conservatism.  Once the economic cycle turns up, of course, the rating agencies have tended to quickly forget this prudence and resume their former generosity to client bond issues.

no market reaction, but lots of expert commentary

Since the ratings downgrade contains no new insights into Japan’s malaise, the reaction from financial markets has been ho-hum.  But pundits have seized on this chance to air their views.  Internal commentators have been beating the drum again for economic reform.  External ones have reiterated their stance that Japan today is a look into the future for the US if we don’t mend our ways.

my thoughts, too

Since everyone else is doing it, I thought I’d also give my views about Japan (yet again), based on my twenty-five years of experience in the Japanese equity market.  Here goes:

1.  Reform just isn’t going to happen.  For decades, Japan has followed a policy of preserving the status quo, even at the cost of no economic growth.  The result has been that creative destruction, where a new generation of firms rises from the ashes of the old, isn’t allowed to happen.  Weak and inefficient entrants in an industry aren’t compelled either to change their ways or fail.  They receive explicit and implicit social protection instead.  So they drag down the strong.

2.  Perversely, the economic stagnation and mild deflation that result from this policy help perpetuate the system.  Lack of economic growth keeps interest rates low. Domestic investors have few viable investment alternatives, so they continue to put their savings into government bonds.    Therefore, Tokyo can fund continuing deficits easily and at low cost.  In a funny sense, the worst thing that could happen to Japan over the next several years would be for the economy to spontaneously (it would take a miracle, though) begin to grow.  Alternatives to government bonds would arise for investors.  And interest rates would likely go up, raising Tokyo’s financing costs.  Voilà, government debt crisis.

3.  There is a point of similarity, I think, between the Japanese situation and the American that is something to worry about.

It’s not in the industrial base, which is much more dynamic and much less hide-bound in the US than in Japan.

It’s not in the politics, either, though both the Capitol and Nagatacho are to my mind similarly dysfunctional.  But the Japanese electorate has put up with legislative failure for over twenty years.  I think, however, as Americans work out that Washington is not meeting its needs, change will come swiftly and dramatically.  We’ve already seen some of this twice within a little more than two years.

One of the most striking aspects of Japan to me as an investor is the strongly held belief in that country of its cultural and economic superiority over everyone else.  The fact of this belief isn’t so surprising.  Every major power seems to think more or less the same thing about itself.  Certainly, the US does, too. But in Japan, sort of like in France, its intensity stands out.  Neither seems to me to have a sense of perspective/humor about itself. (I’ve been told, for example, by a Japanese CEO in a face-to-face interview that he didn’t want foreigners like me holding stock in his company.  Why?  …we’re subhuman, that’s why.  Actually, he told my translator, who skipped over that part–both unaware that a “subhuman” might actually understand a little Japanese.)

If you think it’s a priori impossible for a foreigner to have anything to teach you, you can be blind to the objective situation–meaning that a sense of national pride that’s out of control will act as a barrier to beneficial change.

Although the US may have prominent individuals who believe as intensely as the Japanese/French that anything domestic is superior to anything foreign, I think most of us have a little more common sense.  Again, however, only time will tell.

liquidity trap: what is it? are we in one?

liquidity trap

Over the weekend, Charles Evans, president of the Federal Reserve Bank of Chicago, said at a Fed conference in Boston that he thought the US is in a “bona fide liquidity trap.”  His prescription to cue this situation:  a second round of quantitative easing (basically, the Fed trying directly to push down longer-term interest rates) plus inflation-level targeting (promising to continue loose money policy until inflation reaches 2%).  The purpose of the second is to try to assuage fears of deflation by money market participants.

What does all this mean?

what it is

When the Fed, or any central bank, lowers short-term interest rates, the move has a whole series of effects:

–the initial move signals that the short-term direction of policy is reversing;  the money authority wants to encourage faster economic growth, not slow down inflation

–lower returns on savings instruments tied to short-term rates encourages people to spend money rather than to leave it in the bank

–lower rates on lending money tend to encourage consumers to borrow to finance consumption;  to the extent that younger people tend to be borrowers and senior citizens savers, economic power undergoes a demographic shift that puts money in the hands of those more likely to consume

–arbitrage extends the lowering of rates to longer-maturity debt instruments; lower long-term rates make company investment projects more economically attractive and thus encourage spending on capacity expansion and new hiring.

You can, in theory–and, looking at Japan over the past twenty years, in practice–envision circumstances where this process of lowering interest rates to stimulate economic activity won’t work.  That’s a liquidity trap.  The money authority lowers rates but gets no economic response.

Economists have, not always clearly, distinguished between two types of liquidity trap:

1.  deflationary, sometimes called the “zero bound” case.  The goal of accommodative money policy is to lower nominal rates until they are negative in real terms.  The idea is that once the saver realizes he is no longer even preserving his purchasing power by holding short-term deposits, he will boost his consumption and look for (riskier) investments where he can earn a positive real return.

But nominal rates can in practice only be reduced to zero.  If prices are falling (which is what deflation is), real rates stay high despite the best efforts of the money authority.  If prices are dropping by 3% a year, for example, a zero nominal rate is a 3% real rate.  As a result, savers don’t budge.

There have been instances of negative nominal interest rates–like in Hong Kong in the late 1990s, when the government there announced plans to charge a recurring fee to foreigners for holding bank deposits.  But they’re a practical impossibility.

2.  a “true” liquidity trap, or “pushing on a string.”  The idea is that a point might be reached where central bank action in pumping ever larger amounts of money into the economy would have no further positive effect.  The economy would, in a sense, be saturated with money.  The original thought was that interest rates would remain above zero but would not decline further, despite the efforts of the central bank to push them down.  But the idea can easily be expanded to include other cases where money polity is ineffective:  the transmission mechanism may break down if economic entities are frightened and want to hold precautionary balances even though they earn no economic return; or there may be enough regulatory or government policy uncertainty that it’s hard to identify viable projects to invest in.

where we are now

In the US, inflation has been running at about 1% over the past year or so.  The sharp decline in the dollar over the past several months suggests that, if anything, inflation will rise a bit as we head into 2011.  So, although policy makers and economists may fear deflation, we’re not in that situation today.  That means type #1 above doesn’t apply to us.

There’s a lot of liquidity sloshing around in the US–in the whole world, for that matter.  Several private companies have been able to borrow money at a fixed rate for fifty years or more.  Mexico, despite its history of economic meltdowns and its internal political difficulties, has recently successfully issued a hundred year fixed-rate bond.

This leaves us with breakdown in the transmission mechanism as the reason why money policy has become ineffective.

Mr. Evans of the Chicago Fed seems to think that fear of deflation is the main problem, or at least that’s what his remedy of in effect having the Fed promise to create 2% inflation suggests.  Other economists lack of enthusiastic support suggests his is a lone voice.

This leaves the possibility that attractive investment projects are hard to find.  In a recent speech, the head of the Minnesota Fed, Narayana Kocherlakota, suggested that the gating factor may be lack of skilled workers.  The sound bite the press picked up was his observation that the Fed has no ability to turn construction workers into machinery workers.  He also pointed out that Bureau of Labor Statistics data indicate the economy has about 800,000 more unfilled jobs now than it did in March 2009.

It’s also at least a logical possibility that uncertainty about medical care costs or about future taxes is at the root of companies’ reluctance to invest domestically.  Given that the Fed members are political appointees, though, I think there’s a pragmatic limit to what they’re willing to say in print.  To me, however, it’s clear the Fed thinks a dysfunctional congress and an ineffective president are the reasons the current liquidity trap persists.

I think adjustment to the new economic circumstances is already taking place.  Lack of effective regulation and supportive legislation will just mean the transition process is a longer one.

prospects for deflation: Andre Meier and Gavyn Davies

Gavyn Davies as blogger

Gavyn Davies, formerly chief economist for Goldman Sachs, then head of the BBC, is now among other things a blogger for The Financial Times.

My experience as a portfolio manager has been that Goldman’s economic commentary has always been truly excellent, and the high spot of the firm’s research offerings. As to Mr. Davies in particular, I read and admired his work for years.  (Equity strategy and individual stock research at Goldman is another story—lots of facts, no useful opinions would be my call.)

A recent post on his FT blog talks about deflation.

The  deflation problem, in a nutshell,  is this:  the main tool governments use to treat a sick economy is to lower interest rates to the point where the real (that is, after adjusting for changes in the price level) cost of funds is less than zero.  But an agency like the Fed can only lower rates to zero, where they are now.  It draws the line at actually paying us for the privilege of lending us money.

Because of this, a deflationary economy, i.e., one with a falling price level, is like having a patient with an antibiotic-resistant virus.  You can’t make real rates negative.  So tried and true treatment methods for curing a slumping economy are ineffective.  The monetary authority can either try unconventional methods, which have no track record, or stand on the sidelines with fingers crossed, hoping the patient recovers on his own.

It doesn’t help matters that the word deflation conjures up images of the worldwide depression of the 1930s or the decades-long stagnation of Japan.

Andre Meier on deflation threats

In his post, Mr. Davies cites work by Andre Meier of the IMF in cataloging and analyzing all the instances of recessions in the developed world over the past forty years that have been serious enough to pose a deflation threat.

Mr. Meier’s conclusion:  while inflation does rapidly approach the zero level in the twenty-five instances he looks at, it doesn’t seem to want to cross over into negative (deflationary) territory.  The higher the previous inflation, the faster the plunge downward, but in all cases save two the rate of descent slows and the inflation rate stabilizes as the zero line is reached.

In pre-1990 instances, which tend to originate at higher inflation levels, the march to zero is relatively steady.  Post 1990, the initial fall is sharp, but disinflation then tends to decelerate in later periods.  In the two exceptional cases from the past paragraph, which start from very low initial levels of inflation, Sweden in 1992-94 and Japan 2001-2003, the price level actually starts to rise as the recession deepens (presumably because of currency weakness and imported commodity strength, but odd nonetheless).


Both economists interpret the data as indicating that there’s something very unusual about the occurrence of deflation, and that it seems to take negative economic shocks of much larger magnitude than the world has seen at any time in the post-WWII era–including now–for deflation to take hold.

The question is why this is the case.  Both Meier and Davies point to structural rigidities around zero.  As a practical matter, firms are reluctant to cut the wages of highly skilled employees, for fear they’ll leave when economic conditions improve.  They don’t want to cut the prices of their output, either.  Experience has taught them that it’s extremely difficult–in many cases, nearly impossible–to raise them back again.  In addition, in many cases legally binding agreements–government workers’ salaries, for example, or long-term materials supply contracts–mean price cuts aren’t possible.

On a macroeconomic level, it may be that inflationary expectations–there’ll be low inflation but at least some–have been very deeply established in our collective economic psyches.  World governments response to recent crises, much as we may want to criticize the details, may have been enough to preserve or reinforce these attitudes.

In any event, the experience of the last forty years says deflation is not likely to happen.

my thoughts

No deflation doesn’t mean everything is ok.  But if we take the idea that general price levels are not going to decline as a working hypothesis, we can draw conclusions that may have useful investment implications.  For example, if salary levels aren’t going to decline, then firms will only be able to lower labor costs by laying workers off, or by pruning high-cost but unproductive workers and replacing them with lower-cost, more productive ones.  Companies could also prioritize between high value-added tasks and low value-added ones–and focus all/most compensation increases to workers in the former areas.

One might also try to distinguish countries where limited economic gains may be a chronic problem and those (like the BRICs) where it will not.

In discussing its most recent earnings performance, Procter and Gamble seems to be saying that these sorts of patterns are already becoming evident in their customers’ behavior.  For example, PG is finding that consumers of mainline/premium brands are beginning to trade up.  Value-brand users are continuing to trade down.

My experience is that in uncertain economic times, investors tend to become mesmerized by worry over the worst possible outcome and do little else except wring their hands.  True, we need to be concerned about even low probability events that have significant negative consequences.  But typically this doesn’t take much time.  I think there’s potentially a lot of money to be made by looking for hot spots of growth even in a world that may not be expanding that quickly.  And there’s certainly money to be made by working out the economic implications of having something better than the worst-case scenario unfold.