Tag Archives: inflation

today’s potential inflation threat

June 11, 2013 By in Constructing a Portfolio, Current Market Thoughts, economics, employment, Employment Situation report, inflation vs deflation, Recent Market Action, Strategy Tags: , , , , , , , , Leave a comment

Yesterday I wrote about inflation in general.  My two-post idea has morphed into three, though.  Today I’ll write about the current situation.  Tomorrow, I’ll write about what happened during the last bout of runaway inflation the US experienced, in the late 1970s.

why are the money taps wide open?

It’s partly because we’re wrapping up the fourth year of recovery from the economic lows of 2009 and still have about three million people (2% of the workforce) unemployed.  In those workers lives, today is a repeat of the depression of the 1930s.

As Fed Chairman Bernanke has been saying in testimony to Congress with increasing force, the Fed is not well-equipped to prevent them from becoming part of a European-style permanent underclass.  That’s a job for fiscal policy shaped by the administration and for Congress–stuff like reforming the tax code to stimulate new business formation, or infrastructure spending, or retraining.

But Washington has no interest, leaving the Fed money policy, which is legally obligated through its “dual mandate” to try to maintain full employment, as the only option.  (The Fed’s other mandate, by the way, is to try to create the highest sustainable–meaning non-inflationary–level of GDP growth.)

unemployment is a bigger economic threat than inflation,

in the Fed’s view.  Therefore it feels justified in maintaining its massive money stimulus.

can the situation change?

Inflation in a developed economy starts up when there are more job openings than there are people to fill them.  Companies then begin to headhunt workers away from rivals with large wage increases.  Fast-rising wage levels–together with newly-flush workers’ relative indifference to paying more for things–are what creates overall inflation to spring up.

monitoring the unemployment rate

One way of keeping an eye out for incipient inflationary impulses is to keep track of changes in working hours and wages.  The Bureau of Labor Statistics does this.  The Fed also uses the unemployment rate as its key leading indicator of wages.  The rationale is that it’s hard for a worker to ask for a big raise while there’s a long line of qualified unemployed eager to do the work for the current wage–or less.

one big assumption

Over the past few years there’s been a continuing debate among economists as to how much of the current unemployment is cyclical and how much is structural.

“Cyclical” means that the workers have skills employers want but business in general isn’t strong enough to justify adding staff.  “Structural” means that a potential worker is unemployed because he doesn’t have the skills employers want.  Maybe he can’t use a computer, for example.

The Bureau of Labor Statistics tries to help measure the difference between cyclical and structural through its JOLTS (Job Openings and Labor Turnover Survey) reports.  These show the number of job openings in the US that are currently unfilled.  A new JOLT report comes out at 10am Eastern time today.  The previous one, from May 24th, shows 3.5 million unfilled jobs in the US.  That’s about 10% below the pre-Great Recession highs.  It’s also 75% above the mid-2009 lows of 2.0 million.

to my mind, the JOLTS reports suggest at least part of the unemployment problem is structural–something loose money can’t do anything about.  But no one knows exactly how much this might be.

What if all the open jobs are from tech firms that want to hire college graduates with IT backgrounds, while the three million “extra” unemployed are all high school grads who used to work in construction and have limited computer literacy.  If that were true, we’re already at full employment.  Continuing Fed easing would already be in the process of igniting an inflationary upward wage spiral.

I’m not aware of anyone who is saying this is the case.  But how close are we?  No one really knows.

That’s the risk the Fed is taking–not because it wants to, but because it sees Washington as giving it no other choice.  It’s the reason the Fed is talking about taking its foot off the monetary gas pedal when the unemployment rate is at 6.5%, even though full employment more likely means 5.0%-5.5%.

It’s also the reason, I think, that the financial markets have decided all by themselves in recent weeks–as they typically have in the past–to start to do the Fed’s tightening work for it.

More tomorrow.

is chronic inflation on the way?

June 10, 2013 By in Constructing a Portfolio, Current Market Thoughts, inflation vs deflation, Strategy Tags: , , , , , , , , , Leave a comment

I’m going to write about this topic in two posts.  Today will cover background; tomorrow will ask/answer where we stand now.  In a way, these posts are a follow-on to writing about the employment situation in the US.

inflation…

What is it?

Inflation is a general rise in the level of prices–in other words, in the cost of stuff–that continues over a period of time.

…in a service economy

In a service economy like the US, the largest element in the cost of most things–from financial advice to medical care to computer hardware/software to restaurant meals, and on and on–is the wages paid to the people providing the public with services.  Goods, too.  Because of this, inflation in the US is all about continual rises in wages.

Increases in industrial raw material prices can end up creating inflation here, but only under a number of conditions:

–the price increases for materials can’t be just one-off.  They have to keep on coming.

–manufacturers/ distributors have to pass these cost increases on to consumers by raising their prices, not just absorb them themselves, and

–consumers have to pass the extra costs on to their employers by demanding–and receiving–steady wage hikes.

don’t get inflation started!

Like a lot of things in economics, inflation is partly a state of mind.  A Fed study done when I was just starting out in the stock market demonstrated that at that time consumers’ expectations about future inflation corresponded almost exactly to what actual inflation had been over the prior five years.  It’s not all that surprising that people should extrapolate from recent past experience (what else would you do?), but a problem nonetheless.  If everyone gets it into his head that prices are rising at, say, a 5% annual rate and demands a wage increase that keeps him whole.  So inflation can get institutionalised, as it did in the late 1970s, and become very hard to eradicate.

Multi-year labor contracts may stipulate that wages are automatically increased for inflation–and the define inflation through an index like the Consumer Price Index, which systematically overstates the effect of price rises on the cost of living.  Not a huge issue for today’s US, though.

In addition, inflation tends to feed on itself and starts to accelerate.  In the late 1970s, when an extra-loose money policy sparked inflation, which went from 3% in 1972 to well over 10%–with widespread conviction that inflation would continue to rise–before Paul Volcker stepped in in the early 1980s.

money spigots now wide open again around the world

It’s certainly true in the US and in Japan, and increasingly so in the EU.

The idea is to make the cost of money very low so entrepreneurs will invest and, at the same time, to make the returns low enough on “safe” investments that savers will feel compelled to provide capital.  Why do this?   …to counter the huge economic contraction set off by the near-collapse of the world banking system five years ago.

The risk to this strategy is that, at some point, more productive capacity will be added than there are workers to man it.  If so, labor-short companies will start to poach workers from other firms by offering very large salary increases.  Voilà!  Inflation–always about wages in the developed world–is kindled.

More tomorrow.

the Fed’s QE3: a “reverse Volcker moment”?

September 21, 2012 By in inflation vs deflation, Strategy Tags: , , , , , , , , , , , Leave a comment

The most recent A-list editorial feature in the Financial Times, written by Pimco marketer Mohamed El-Erian, asks this question and answers it with a carefully hedged “Yes.”

Several aspects of the editorial are interesting:

–it’s not the usual El-Erian turgid statement of the obvious.  Instead, it’s concise, well-written and makes a point.  To me, this underscores the fact that Mr. El-Erian is writing, not as an individual, but as the voice of the collective wisdom of the largest and most successful bond investment management firm in the US.  As such, the opinion expressed should be taken seriously.

–the original “Volcker moment” was Paul Volcker’s decision as newly-appointed Fed chairman to deal with runaway inflation in the US by raising interest rates to extremely high levels for an extended period of time.

The editorial suggests Mr. Bernanke is currently in the process of deliberately trying to manufacture higher levels of inflation, thus reversing the major thrust of Fed policy over the past thirty years.  Calling the move a “reverse Volcker moment” implies that the decision may have equally momentous implications (more about this next week).

–although the editorial doesn’t say this (Pimco markets bond funds, after all), such a Fed policy reversal would likely have negative consequences for all securities markets, but especially unfavorable ones for bonds.

At present, long Treasuries yield about 3%, which we can break out into a 1% real yield and 2% as compensation for benign, stable annual inflation of around 2%.  If the world began to think that inflation in the US could be 3%–and rising–how would bonds be priced?  …at a 5% yield?  …higher?

That’s a big difference, one which would produce significant losses for current Treasury holders.

Barney Frank’s idea of “reforming” the Fed

September 18, 2011 By in economics, Portfolio management, Recent Market Action, Strategy Tags: , , , , , , , 2 Comments

the Fed’s Open Market Committee

The Fed’s Open Market Committee, which determines the Fed’s interest rate policy, consists of 12 members.  Seven are appointed by the president, five are taken on a rotating basis from among the heads of the 12 regional Federal Reserve banks.  The regional bank heads are selected by the boards of directors of their respective banks–typically prominent local businesspeople–and approved by the Fed’s board of governors.  The Huffington Post has the best synopsis I’ve seen.

the Frank proposal

Barney Frank, the senior Democrat on the House banking committee, is trying to change that.  According to Bloomberg, Mr. Frank wants the five regional banker votes eliminated.  They would be replaced by four appointees chosen by the president.

Why the change?  In Mr. Frank’s opinion, the current procedure isn’t “democratic” enough, because the regional Fed chiefs aren’t vetted by publicly-elected officials.     …and, oh, by the way, Mr. Frank also disapproves of the way the regional Fed chiefs vote.  They’re too worried about inflation (that is, about sound money).  Looser money policy than they’re willing to tolerate might help spur job growth, he thinks.  Presumably political appointees would vote as they’re told to by their political bosses.

Basically, then, Mr. Frank’s goal is to induce a significant level of inflation in hopes of creating jobs.

This is a bad idea.

The one sure effect of a higher level of inflation would be to weaken the dollar.  That would doubtless frighten the foreigners who own huge amounts of Treasury bonds, causing them to demand higher coupon rates before they roll over their holdings as existing bonds come due.  In fact, the last time the US was in this situation, during the Carter administration, foreigners flat out refused to buy dollar-denominated bonds from the US.  They not only demanded higher rates; they demanded to be repaid in harder currency, like the D-mark, before they would lend Washington money.

During the same period, companies stopped investing in new plant and equipment.  Rising inflation made it too hard to figure out whether these investments made any economic sense.  Then there was the mammoth recession of 1981-82, when interest rates rose above 20% as Paul Volcker set about putting the inflation genie back in the bottle.  At the time, it was conventional wisdom that this process caused so much economic hardship for the country that no one would advocate reintroducing inflation into the economy ever again in our lifetimes.

So more inflation = high interest rates + weak currency + economic slump = higher unemployment + personal bankruptcies + business failures.

Would anyone want that?

But here’s Mr. Frank, who lived through the pain once–and who should know better, eager to take the risk of this happening again.

Why, Barney?

It may be that Mr. Frank, as a Democrat in a legislative chamber controlled by the Republicans, figures he can make a political statement without any risk, because no bill of his will ever pass the House.

Even so, the pro-labor/anti-business tone of his proposal invokes memories of an era of class struggle in the US that ended half a century ago.  It may resonate with voters in their seventies or eighties; anyone younger will likely just regard the Frank bill as I do–irresponsible and dangerous.

investment implications

Higher inflation means lower bond prices and lower price-earnings multiples for stocks.  Any threat to the independence of the central bank will create big problems financing government debt.  It may not be foreigners who balk at buying Treasuries, either.  Historically, domestic bond investors have been the first to react when government policy threatens the value of their investments.

My guess is that the Frank bill is DOA.  Given that far-right Republicans also want to lessen the independence of the Fed, however, I think the situation warrants continuing monitoring.

S&P downgrades Japan: a cautionary tale?

January 31, 2011 By in Asian economic development, economics, government debt trap, Japanese development Tags: , , , , , , , Leave a comment

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.