Tag Archives: inflation

inflation: where we are now

June 25, 2014 By in economics, inflation Tags: , , , Leave a comment

Yellen

In the early days of the financial crisis, after the Fed had opened the monetary flood gates and aggressively pushed short-term interest rates down to zero, Janet Yellen commented on the cries of prominent hedge fund managers that this would immediately lead to disastrous runaway inflation of the type that plagued the US in the late 1970s.  Her reply was “We should only hope,” or words to that effect.

She didn’t elaborate   …but I will:

1.  The threat to the world at that time was just the opposite of inflation.  The real threat was deflation, or systematically declining prices.  If prices are falling at the rate of, say, 2% a year, making monetary policy accommodative means lowering the Fed Funds rate to -4%.  In practical terms, this is impossible.  So monetary policy is ineffective and a rerun of the Great Depression ensues.  Clueless financiers to the contrary, everything possible had to be done to avoid the deflationary outcome.

2.  Inflation , in contrast, is a little like the flu.  Treatment is well-understood and straightforward to put into effect.  So, yes, it may be unpleasant but we definitely know how to handle the situation.

where are we now?

The biggest problem the Fed has continues to be that it can’t create enough inflation.  The price level has remained stubbornly under the Fed’s target of a 2% average annual increase.

In the US at least, inflation is all about wages.  Nothing else is big enough to matter.  The (lack of) inflation problem is that there’s still enough available labor in the economy that employers don’t have to raise wages, either to find new workers or hold onto existing staff.

On the one hand, the Fed would like to begin to return interest rates to normal:  a

–five-year ICU stay can’t be good for a patient;

–with rates at zero the Fed has no ability to respond to any other economic disruption;

–world bond markets appear awfully bubbly at the moment; and

–the Fed is arguably an enabler of a dysfunctional Congress/administration.

On the other, the last thing the Fed wants is to choke off growth and create a recession.

my take

Personally, I’d expected the too-many-employers-chasing-too-few-workers syndrome to have developed long before now, and that we’d have 2%+ inflation already.  That’s because I believe that a lot of current unemployment is structural, not cyclical.  That is, I’ve been thinking that many long-term unemployed don’t have the educational or technical skills needed in the 21st century workplace.  Loose money policy doesn’t do them any good.  They need retraining, not low rates.

So far, that’s been wrong.

Taking back of the envelope numbers, there are about three million unemployed workers in the US.  The economy is now creating about a million new jobs a year more than the number needed to absorb people leaving school and entering the workforce for the first time.  If these are the only factors, and if I continue to be 100% wrong (that is, if there’s no structural unemployment), then we won’t reach full employment until 2017.

This would imply that we won’t have to worry about inflation for a long time.  This would also imply that the bond market–and, consequently, the stock market too–could get a lot weirder before the Fed pulls in the reins.

 

two types of inflation?

June 24, 2014 By in Asian economic development, economics, inflation, Japanese development Tags: , , , , , , , Leave a comment

two forms

Back in the 1970s, when inflation actually was a serious global economic problem, economists tried to distinguish between two types of inflation:

demand-pull

—demand-pull is what we typically think of as inflation today.  It’s the situation where an economy is at full industrial capacity and full employment but is still growing strongly.  The only way to find new workers to staff business expansion is to lure employees away from rivals.  How to do this is?  …offer them more money.  An intercompany bidding war for talent ensues. Salaries rise.

Newly flush workers want to spend on goods and services.  But these are also in limited supply because industry is capacity constrained.  How to get the stuff we want?   …bid higher prices.

Voilà!   …rip-roaring inflation.

This problem can be laid squarely at the feet of too-loose money policy.

cost-push

—cost-push.  This is the idea that the price of one or more key agricultural or mineral commodities rises by a lot (think;  the two oil shocks of the 1970s, when crude doubled or tripled in price).  Such a price increase is passed on to manufacturers and to consumers, causing the overall price level to rise.

This type of inflation is no longer talked about, for several reasons:

—-monetarists have successfully argued that oil shock inflation was caused more by the decision of central banks to soften the blow by rapid money supply expansion than by the price increase itself.  It was, they said, accommodation that caused the inflation, not oil.  After all, falling oil prices in the 1980s didn’t cause deflation.

—-wages are no longer routinely indexed for inflation for the vast majority of workers, so a key pass-through mechanism is no longer operating

—-advanced economies are much more involved in providing services that use intellectual resources, which are less subject to the physical constraints of plant, mine or farm capacity.

—-globalization has put significant upward pressure on commodities prices, but has also created downward pressure on wages in industries making tradable goods.  Of course, in the internet age, a lot more stuff is in the tradable category, too.

—-advanced economies, particularly the US, have evolved to the position where labor costs are perhaps three-quarters of the total economy, and therefore effectively the only thing that matters.

cost-push making a comeback?

I think so.

Japan recently depreciated the yen by 20%.  This has caused a surge in profits for export-oriented manufacturing, and a tsunami of Asian tourists seeking to buy, among other things, heated Toto toilet seats.  Prices have shifted from falling to rising.

But wages haven’t gone up at all.  So, yes, the depreciation has created inflation, but most individuals are worse off than they were before–because they’re paying 20% more for imported items like fuel and food.  (This isn’t quite correct.  There’s a substitution effect along with the income effect, meaning that people shift what they consume in order to lessen the harm to their well-being from higher prices.  They, say, eat tofu instead of beef or get clothes from a consignment store instead of Uniqlo.)

There’s also the effect of price rises on the long-term unemployed in the US or the EU.  It’s not quite the same thing, but it’s certainly different from the demand-pull world, where everyone is better off–but tricked by the fact nominal (but not necessarily real) wages are rising into thinking they’re better off than they are.

investment significance?

I’m not sure, other than to take a trip to Japan before the place falls apart.

But I do think that the failure of wages to rise, either in Japan or the US, despite highly stimulative monetary policy is a potentially explosive social/political issue.   It may reach a tipping point where big social changes are demanded.

 

 

 

what’s bad about inflation?

June 23, 2014 By in Current Market Thoughts, economics Tags: , , , , , Leave a comment

this is the first of several posts about inflation, which may turn into an important investment issue this year or next.

what it is

Inflation is a sustained rise in the level of prices in general.  An environment of modest inflation–the Fed’s target is an average 2% yearly increase–is the desired mode of operation for Western economies.  It’s what people are used to.  Government and university economists feel they understand how inflation operates and know what to do if it starts to get out of control.  They all agree, moreover, that inflation is a lot better than deflation, a sustained fall in the price level, whose effects have historically been devastating and for which there’s no tried-and-true cure.

what’s bad about inflation

Inflation has two bad characteristics, last seen in the US in the 1970s, that make it an object of concern:

inflationary psychology

If goods or services are in plentiful supply and if prices don’t change very much, buyers will purchase things when they need them.  If buyers think that prices are rising in a sustained and significant way, they’ll begin to buy ahead of time.  Some will buy more than they’ll ever need, either with the intention of selling later at a profit or simply viewing their purchases as a store of wealth.

Once ingrained in individuals and companies, as it became in the Seventies, this behavior is hard to change.  But it sends crazy signals to the providers of goods and services, who rev up production as fast as they can to meet this new demand.

Once convinced that inflation is here to stay, the economy begins to distort itself.  Interest swings toward the production/acquisition of items whose chief/only merit is that they are perceived as inflation hedges (think:  gold, diamonds, real estate,  oil and gas).  In the late Seventies, for example, industrial companies leveraged themselves to the sky to buy coal mines or hotels–things they knew nothing about, and whose purchase they would soon come to rue, but which they thought defended themselves against accelerating inflation.  If they could borrow from banks at fixed rates–which was the general practice back then–they figured that the real cost of their debt would soon turn negative, giving them further gains.  Once the Fed stepped in to halt the inflationary spiral, these firms (and their banks) were ruined.

In short, once inflationary psychology develops, an economy begins to go off the rails.

a tendency to “run away”

Three factors cause inflation to accelerate–and economic craziness to get out of control.  They are:

–Inflationary psychology tends to feed on itself.  Once you see the hundred pounds of pig iron you have in your basement has gone up 50% in price, you buy more   …as time goes on, a lot more.  As companies/individuals realize that “buy now” is a successful strategy, they expand the depth and scope of their activity.

–Some price rises are automatic, adding to the price rise momentum.  Labor contracts, for example, may have clauses that adjust wages for inflation.  Traditional pensions, too—and Social Security.  Utility companies typically are allowed to pass increased costs directly on to consumers.  In addition, these institutionalized price increases often use escalation formulas that overstate inflation (think:  Social Security).

–Some parties may systematically underestimate inflation and inadvertently throw gasoline on the fire.  For most of the 1970s, for example, the Fed set money policy that was much too loose, based on faulty inflation projections.  Banks typically didn’t protect themselves by lending at variable rates, either.  Potential borrowers soon learned that they could do a lucrative arbitrage by taking out a long-term loan at a rate that would soon turn negative and use the money to buy “hard” assets that would appreciate in value.  This became the focal point of many firms’ capital spending plans.

1970s vs. 2010s

A generation ago, the “runaway” factor was extremely powerful in the US.  That was partly because of bank activity and partly because a large portion of the labor force worked under multi-year collective bargaining agreements with inflation adjustment factors.  Much more so in Europe.

Today’s banks lend at variable ares and are no longer a pro-inflation force.  Labor arrangements have changed a lot in the US over the past forty years, though not in continental Europe.

As a result, my guess is that the tendency for inflation to accelerate is considerably lower in the US now than it was the last time we had an inflation problem.  One offset:  the early Volcker years, during which the Fed was successfully breaking an upward inflation spiral through super-high interest rates, were ones of severe economic hardship.  The memory of that pain was enough to engender a “never again” attitude toward too-loose money that lasted for almost twenty years–until the latter days of Alan Greenspan.  I think that mindset is gone now, not only from the Fed but from popular consciousness as well.

More tomorrow.

 

 

 

 

pining for inflation to return

November 15, 2013 By in Constructing a Portfolio, Current Market Thoughts, Dividend Discount Model, growth vs value, inflation vs deflation Tags: , , , , , , , , Leave a comment

background

Every macroeconomics student quickly learns the lesson of the Great Depression–that deflation (an environment where prices in general are falling) is the gravest ill that can befall a country.  Why?   …for companies, deflation means continuously declining revenues.  At some point, the firm can no longer meet its payroll.  Eventually, it can no longer service, much less repay, any borrowings it may have.  As the 1930s showed, deflation breeds widespread unemployment and corporate bankruptcies.

Second place on the list of bad things that can happen goes to runaway inflation (accelerating rises in prices in general), a malady common in emerging economies–and one the US experienced in the 1970s.  The issue here is that no one knows what interest rates in the future will be–only that they’ll be crazy high.  So no one, neither individuals nor companies, invests in long-term projects–because they can’t figure out whether they’re money-makers or not.  Instead, everyone starts to shun financial assets in favor of buying and hoarding tangibles like gold or real estate, sometimes in a completely loony way, on the idea that they will rise at lest in line with the soaring price level.

When the US began to fight its incipient runaway inflation under Paul Volcker in the early 1980s, the question arose among  academic economists as to what was the “right” level of inflation.  The consensus answer:  2%.  Not so close to zero as to say “deflation,” but low enough not to suggest “runaway.”

So 2% inflation became the holy grail of US, and global, monetary policy.  It took the US twenty years to hit this target.

the present

Over the past several months, I’ve been reading and nearing comments from lots of different sources that suggest that 2% may be the wrong answer.   Not the academic world, of course.  Two reasons:

1.  The Fed has been perplexed at its inability to keep inflation at 2%. The number seems to want to gravitate toward zero, instead.  This raises the specter of deflation, the sure-fire investment killer.  So this tendency is bad.

2.  For small businesses, which have been the biggest engine of economic growth in the US in recent decades, a 2% rise in prices + at best 2% real growth = a 4% increase in annual revenues.  The first objective for most family-owned firms is to make sure that this year’s profits won’t fall short of last year’s.  That’s because any shortfall is money out of their pockets, not simply a theoretical loss.  Apparently, +4% in revenues isn’t far enough away from zero to create enthusiasm for taking the risk of investing to expand the business.  Therefore, no capital projects, no new hires.

significance?

Two reasons are most often cited for the current slow growth in the US:  hangover from the Great Recession and dysfunction in Washington that prevents growth-promoting fiscal policy from being enacted.

I think a consensus is beginning to form that there may be a third culprit–an inflation target that has been set too low and which has inadvertently mired us in a kind of Bermuda Triangle monetary situation that  the Fed can’t extract us from by itself.

This implies fiscal policy may be the only cure for sub-par growth.  Therefore, ineptitude in Washington, even if that has been the norm forever, is no loner as tolerable as it has been in the past.

If this is so, growth stocks will continue to outperform value names in a slow-growth economy–unless/until fiscal policy gives a helping hand.

the late 1970s: the last real inflationary period in the US

June 12, 2013 By in Constructing a Portfolio, Current Market Thoughts, economics, inflation vs deflation, Strategy Tags: , , , , , , , , , Leave a comment

inflation in the 1970s

The most recent US experience with a real inflationary spiral came in the late 1970s.  In early 1977, prices were rising at a 5% annual rate.  A year later, inflation was running at 7%.  A year after that, the number was 9%, with 14% posted in early 1980.  Then Paul Volcker was appointed as Fed chairman.  He pushed the Fed Funds rate from 11% to 20%, creating a deep recession but breaking the back of the inflationary psychology that was feeding the accelerating rate of price rises.

There’s an academic debate, itself with political dimensions, as to what caused the spiral in the first place.  One side says it was a series of mistakes by the Fed, whose inflation forecasts were systematically too low–that therefore its setting of short-term interest rates(the main tool it used to regulate the economy) was, too.  The other side says it was Washington’s political meddling.

who lived through it?

If you were in your mid-twenties in 1975, when the world was just emerging from a horrible recession (the UK had to call in the IMF to rescue its economy), and the subsequent inflation problem was just being ignited, you’d be in your sixties now.

In other words, virtually all commentators about the perils of inflation today have no practical experience with the phenomenon.  Most of them are clueless.

two parts to runaway inflation

In my view, for what it’s worth, runaway inflation has two characteristics:

1.  money policy that’s too accommodative (read:  interest rates are too low), and that stays that way in the face of rising inflation, and

2.  a resulting mindset change that accepts rising inflation as a fact of life and seeks to benefit from it.

how people deal with rising inflation

I’ve seen this behavior in the US in the late 1970s, and also in high-inflation emerging economies around the world since then:

1.  The price of everything is going to be higher tomorrow than it is today. So you should buy now, rather than wait.  That’s true of everything …houses, cars, clothes, appliances.  If you have to borrow, do it!  In fact, if you can borrow at a fixed rate, inflation will probably soon make the loan look like a gift from the lender and you’ll profit from that, too.

Companies will load up on extra raw materials inventories, expecting to profit from holding them while prices rise.

2.  Workers will look for protection from inflation through contracts where wages are indexed for inflation (wages will rise in lockstep with the general price level). Companies will look for the same in multi-year sales agreements. Many contracts signed in the 1970s had prices indexed to the CPI or other indices that overstate inflation.  Good for the seller, but this also added to the inflation problem.

3.  Economists talk a lot about “money illusion,” the idea that most people can’t figure out how fast prices are rising.  So they’re satisfied with, say, a 5% raise when prices are going up by 8%.  In reality, that’s a 3% wage cut, after inflation.  Of course, once you’re aware of this possibility, you’ll ask for a 10% pay increase–fueling the inflationary fires.

4.  Investors of all stripes will look for assets that will protect them from rising prices.  Typically, these would be physical things, like property, oil and gas or metals.  At the same time, they’ll shun financial assets.  Investors may even short financial assets by borrowing heavily, at fixed rates when possible.

In fact, in the late 1970s many companies made what turned out to be disastrous acquisitions as they tried to work the inflation game, with, say, an industrial parts maker borrowing heavily to buy a coal mine or a chain of hotels.  These turned into almost certain recipes for Chapter 11 after inflation was tamed.

At one time in Brazil, investors bought used cars and stacked them up in their back yards as inflation hedges.  Sounded good at the time, but…

5.  Stock market investors will look for hard-asset companies or firms that can grow their profits at a faster rate than nominal GDP.  This excludes most defensive industries, like telecom or gas/electric utilities, where rates of return on investment are regulated, or like staples, where large price increases cause consumers to look for cheaper substitutes.

an alternate reality

Sounds like an alternate reality?  I think so.

But that’s the point.  It shows how far away from an inflationary environment we are today.