Tag Archives: inflation

Minutes of the June 22/23, 2010 Federal Open Market Committee

July 16, 2010 By in Current Market Thoughts, Discounting, economics, Portfolio management, Recent Market Action, securities markets, stock market, Strategy Tags: , , , , , , , , , , , , , Leave a comment

the June OMC meeting

The minutes of the Federal Reserve Open Market Committee meeting of June 22-23 were released on July 14th.

To my mind, the truly striking development in this report is not the economic numbers themselves.  It’s the fact that for the first time since world stock markets bottomed in March of last year, the forecasts of the country’s near-term economic prospects by the 17 members of the OMC (5 governors + the 12 presidents of the regional Federal Reserve banks) have stopped going up.  In fact, they’ve gone–at least temporarily–into reverse.

The Fed now thinks real GDP growth in 2010, at 3.3%, will be .25% less than it thought in April.  The unemployment rate is expected to remain about .2% higher than previously estimated, at 9.4% this year and 8.5% next.

What’s changed?

To be clear, the Fed believes that the US economy is in the process of a moderate, but self-sustaining economic recovery, where “inventory adjustments and fiscal stimulus were no longer the main factors supporting economic expansion.”  But it also thinks that several factors, most of them external, have recently emerged that put a firm upper limit on how fast the economy can advance.

They are:

–financial troubles in Europe

–the rise in the dollar, and

–weakness in stock prices (even with the recent rally from just about 1000 on the S&P 500, Wall Street remains 10% below the high water mark achieved earlier in the year).

They add to business and consumer uncertainties, real estate weakness and reluctance of banks to lend, as sources of the headwinds the domestic economy is facing.

The good news, then, is that the US is on an upward course.  The bad news is that what we see now is as good as it gets.

the US economy:  plusses and minuses

–industrial production gains are “strong and widespread,” with IT investment growing rapidly,

—but capacity utilization remains low enough that companies aren’t going to invest in plant and equipment for expansion (vs. replacement or upgrade) for some time to come.

–labor demand continues to firm,

—but the proportion of workers jobless for more than half a year, already unusually high, continues to rise.

–bank credit, “which had been contracting for some time, was showing some tentative signs of stabilizing,”

—but commercial real estate is weak, with no bottom in sight,

—and consumer credit keeps on contracting.

–inflation remains unusually low, with deflation a risk,

—but the current lack of inflation has not yet caused Americans to adjust their inflation expectations down, thus raising the deflation risk.

the bottom line

Economic growth will remain muted, and unemployment will therefore  remain unusually high for an extended period of time, with most OMC members expecting “the convergence process (to normal unemployment levels) to take no more than five to six years (emphasis added).”

In consequence, inflation will remain unusually low for a similar extended period, gradually rising to around 2%.

long-run projections

change in real GDP      2.4%-3.0%

unemployment rate     5.0%-6.3%

CPE inflation     1.5%-2.0%

investment implications

Wall Street has always been able to draw a clear distinction between sectors it thinks will perform well and those it thinks will perform badly.  And it has usually been able to separate that judgment from one about whether the overall market will go up or down.

Foreign stock markets have routinely been able to draw a similar kind of high-level distinction between the prospects for the home-country economy and those for international regions.  They have usually been able to vary their holdings between domestic- and foreign-oriented companies, and to disconnect that decision from one about whether the market will go up or down.

Right now, the US economy overall, and consumer-oriented sectors in particular, seem to me to be relegated to the laggard column for some time to come. It also seems to me that the overall market is cheap.  Or, as the Fed put it in its minutes, “The spread between the staff’s estimate of the expected real return on equities…and…the expected return on a 10-year Treasury note…increased from its already elevated level.”

American investors have clearly been able to make the inter-sector judgment without difficulty.  If the market can do the same for the foreign-domestic judgment–and that remains to be seen–IT and international-trade related firms should have smooth sailing in the year ahead.

two other thoughts

The notion that the economy won’t be back to normal for the next half-decade is shocking, but given the enormous amount of damage done by the financial crisis (the Washington-Wall Street complex) it’s not that surprising.  The realization of this fact is probably the cause of the large amount of public outrage directed at politicians and investment/commercial bankers.

Although the negative news about GDP growth and extended high unemployment have been widely reported, the Fed projections have barely made a ripple in the stock market.  Presumably, this means that investors have already discounted most of this n stock prices already.


inflation as politics

June 28, 2010 By in Basic Concepts, China, Current Market Thoughts, economics, inflation vs deflation, Strategy Tags: , , , , , , , , , , , , Leave a comment

I’m going to write here about what I perceive the political dynamics of inflation in the United States to have been in the past century.  I presume, but don’t know, that the same process can and has occurred elsewhere.

early days

The latter part of the nineteenth century and the first half of the twentieth were times of what amounts to class struggle in the US between business and labor.  Issues ran the gamut from child labor and workplace safety to wage levels and unionization.

The sides coalesced around two political parties, the Democrats representing labor and the Republicans defending business.

(This struggle is basically over today, I think–leaving both major parties trying without a great deal of success so far to redefine themselves.  For good or ill, most Americans no longer draw a sharp distinction between management and labor.  This is partly because the nature of work has changed, partly because most Americans consider themselves part of management.)

During the time when workers were fighting for what we would now regard as basic, and self-evident rights, inflation became a significant weapon in the battle.  How so?

inflation and bonds

A conventional bond is a series of interest payments made to the holder plus return of principal at the end of the bond’s term.  The present value, or value today, of the bond is the sum of all these payments by discounting each back to the present using an appropriate interest rate.  The higher the interest rate employed, the lower the present value.

the holder

A rising inflation rate erodes the present value of a bond.  If, for example, when the holder purchases it, inflation is at 3% the buyer may be content with a 6% coupon.  He receives $60 a year in interest payments and his $1000 back a the end of the bond’s term.   The interest payments offset inflation and provide a real return of 3% annually.

Suppose the inflation rate rises to 7% immediately after the holder purchases the bond.  Suddenly, he is no longer receiving a real return on his money.  Part of the purchasing power of his investment is disappearing, due to the higher rate of inflation.

the seller

Conversely, the seller benefits from an increase in the inflation rate, since that results in a real decline in the value of the payments he has agreed to make to the holder.

back to politics

It seems to me that during the late nineteenth and early twentieth centuries a basic assumption of the Democrats, the party of labor, was that its constituents held no physical or financial assets.  In fact, many might be net borrowers, or, as the financial world would put it today, be “short” financial assets.  Their main source of economic worth was their ability to sell their labor.

In contrast, Republicans thought of their constituents as the “longs,” wealthy bond-coupon clippers, with ownership of vast amounts of physical and financial assets.

two opposing agendas

These differences set the agendas of the two parties.  If the Democrats were in power, they could attempt to transfer wealth from business to labor overtly by increasing taxes on the wealthy and/or by raising benefits provided by the government to workers.  Or they could do so covertly by establishing economic policies that induce inflation.  That would decrease the wealth of the old time robber barons–and at the same time it would lessen the real value of the loans workers had taken out from them.

When the Republicans were in power, they would start to undo the policies initiated by the Democrats, by trying to balance the government’s books and by fighting inflation with restrictive economic policies.

I think this is the way Washington worked even through the 1970s.

the new order

Not any more, though.

The nineteenth century model was one of massive capital investment in plant and equipment (think: blast furnace steel) operated by manual labor.   Accelerating rates of technological change have destroyed that economic model.  Who are today’s economic heroes?–Google, Apple, Amazon, Pixar, biotech…  They are relatively small groups of highly educated people creating service businesses that require little physical capital, many of them using the internet as a substitute for having a large advertising budget and extensive physical distribution facilities.

the old dynamic reborn

At present, most domestic economists are praying for any sign of inflation to emerge, simply to give the US some breathing room against the possibility of deflation.

Beyond this, however, inflation has reemerged as a political issue in the US.  The new dynamic has arisen from the fact that Washington has borrowed heavily from foreign governments–notably Japan and China–as well as from domestic sources.

So the drama of the first half of the twentieth century has been recast, with the Chinese in the role of big business and Washington in the role of labor.  It is certainly tempting to lawmakers to attempt to repay foreign creditors in inflation-diminished dollars rather than to have to have tax revenues large enough to generate the entire real amount owed.  On the other hand, China, sensing this line of thought, has been increasingly vocal over the past year or so in its concern that Washington protect the purchasing power of the dollar through economic orthodoxy.

This new drama is still in rehearsals.  The collapse of the euro has meant it won’t need to open on Broadway any time soon.  But it will still be important to monitor how the play is shaping up.


inflation vs. deflation: where are we now?

June 27, 2010 By in Basic Concepts, economics, inflation vs deflation Tags: , , , , , , , , 2 Comments

Because the two words, inflation and deflation, look alike, they invite the conclusion that there’s a single phenomenon– -flation–that has two varieties, de- and in-.  As a practical matter, despite the similar names, inflation and deflation are actually quite different in how they affect an economy.   In the US at present, knowledgeable politicians (an oxymoron?) and economists have their fingers crossed that inflation somehow resurfaces and that deflation will not become an issue.

inflation

An economy with inflation is one where the price of things in general is rising.  It isn’t enough that some prices are rising–even very visible prices like gasoline or movie tickets.  In an inflationary economy, overall prices have to be rising, so that the cost of living steadily goes up. (I wrote about inflation more extensively in a post from May 25, 2009.)

In a developed economy like the US, the only price that really counts for inflation is the price of labor.

If inflation had a tendency to stay well-behaved, at a constant, low rate, it wouldn’t be much of a problem.  But it usually doesn’t do either.  One way to think about what happens is this:

in an inflationary environment, some people underestimate inflation.  They think prices will rise by, say, 3% in the coming year.  They ask for and get a 3% wage increase.  But inflation turns out to be 4%, so in real (i.e., adjusted for price-level changes) terms they are making less than they used to.  So the following year, they ask for a 6% raise.   Others ask for and receive a 5% raise, so they’re better off in real terms than before.  So they try to do the same thing the following year.  As a result, the rate at which prices are rising tends to increase.

At some point, expectations change. Companies start to raise the prices of their output and individual wage earners up their wage demands in anticipation of, and as protection against, future inflation increases.  In doing so, they create the increased inflation they fear.

As inflation accelerates, people start spending more and more time defending against future price increases and trying to work the situation in their favor.  This means less time doing productive work.  At more advanced stages, capital investment in long-term projects slows, because figuring out its profitability may depend on forecasting accurately what inflation will be ten years hence–which has become impossible.  For the same reason, no one wants to hold fixed income securities, including government debt.

In the worst case, hyperinflation (think:  Japan or Germany close to a century ago, or Brazil twenty years ago), the economy comes close to collapse.

The (relative) good news about inflation is that it’s a well-understood phenomenon.  Any government knows what to do to remedy the situation:  restrictive policy (higher interest rates, plus maybe less government spending and higher taxes) until inflation begins to decline and expectations in the economy change.   The real stumbling block to an inflation cure is having the political will to implement it and a Paul Volcker-like central banker to oversee the process.

deflation

In its definition, deflation is the opposite of inflation.  It’s a steady, general fall in the price level.  To my mind, three factors make deflation something different from a mirror image of inflation.

1.  Deflation is weird. Other than the Great Depression or the Weimar Republic, it hasn’t occurred very often in the contemporary world.  Other than maybe the PC industry, no one is set up either psychologically or institutionally for deflation.  Suppose prices were falling at a steady annual rate of 2%.  What would you think of a government bond where you paid $1000, received no interest income and got back $900 in ten years?  Me, too.  Credit creation, and all the economic activity that depends on it, would stop dead in its tracks.

2.  Deflation makes outstanding debt that carries a positive nominal interest rate (in other words, all of it) a crushing burden.  Prices dropping 2% per year means, among other things, wages dropping 2% annually.  Let’s change the rate to 5% just to make the point easier to see.  At the end of five years, you’re making 77% of what you were before deflation hit (ignore the fact that falling wages suggests widespread unemployment and other horrible economic problems).  Yes, the cost of food and clothing has probably fallen in line with your income, but your mortgage and credit card payments haven’t.  If your credit payments were 25% of your income pre-deflation, they’re a third–and rising–of your income now.

The situation is worse for companies with operating leverage, whose profits can quickly disappear.  Imagine, too, the state of private equity or commercial real estate, which depend on high levels of financial leverage for their viability.  They’re toast.

This, of course, has knock-on negative effects on the banking system.  Look at the Thirties.

What a mess!

3.  Traditional money policy becomes ineffective.  The orthodox central bank response to recession is to lower short-term interest rates until they’re negative in real terms.  The fact that finance is in effect free is supposed to stimulate borrowing, and therefore reinvigorate economic activity.  But the central bank can’t push nominal (i.e., not adjusted for inflation/deflation) short rates below zero.  So in a deflationary environment, the central bank can’t achieve the “free money” outcome.

This means that a country depends completely on fiscal stimulus–increased government spending–to help the economy improve.  But legislative action may be slow.  There’s huge potential for spending programs to be applied in pork barrel ways that will do little more than run up the government’s debt burden (think:  Japan since 1990).

where are we now?

There’s good news and bad news, in my opinion.  Bad news first.

Government stimulus programs seem to me to have so far been focussed on whatever is “shovel ready,”  without much thought about addressing long-term structural problems like education.  Maybe that will change.  But to date Washington looks scarily like Tokyo circa 1990.

The good news–

Europe’s pain is our gain.  US government spending depends on the continuing willingness of foreigners, notably China, to lend Washington money.  Prior to the Athens-induced collapse of the euro, Beijing appears to be warming up to shift its lending activity away from the US.  Not any more.  So no matter how inefficient government stimulus may be, at least it does something positive, and it won’t come to a screeching halt.

Also, lots of companies are announcing that business has become good enough that they are beginning to raise wages again and reinstitute benefits cut during the recession.  Given that wages are the most important element of changes in the price level in the US, this suggests that the current near-zero inflation rate is a cyclical low point and that the price level will rise from here.  To some extent, this movement in the private sector will be offset by changes in state and local government workers’ payrolls (some studies claim that municipal employees are now paid 20% more than private sector workers for the same jobs).  Still,  I think the private sector trend is grounds for a loud sigh of relief.


Balance of Payments (II): internal and external structural adjustment

March 25, 2010 By in Balance of Payments, Basic Concepts, currency effects, economics Tags: , , , , , , , 1 Comment

The BoP accounts should balance

In the long term, the balance of payments accounts for a given country is supposed to balance, that is, net out to zero.

a simple example

This is a common sense notion.  It’s easiest to see if we take a simple, theoretical example.  Assume a world where there are only two countries, A and B, where all exports are priced in the local currency and all imports are priced in the foreign currency. (Everyone knows the first assumption isn’t true, but in the real world the second one isn’t, either.)

Further, call the currency of A the $ and the currency of B the @.  Let’s take the initial exchange rate as $1 = @1.

a trade/current account deficit…

Let’s take the case where country A produces $1 billion of goods that it exports to B, but still has an annual trade deficit of $100 million.  It gets @1 billion for the goods and services it exports to B but it still has to get another @100 million from B to pay for the extra $100 million of imports it purchases.

Where does this extra @100 million come from?  Not from today’s income-earning activities in country A.  Looking at the other balance of payments accounts, the other @100 million might come from dividend or interest payments from abroad.  If it doesn’t–and this is the most likely case–country A has to sell things to B to get the extra @100 million.  This “selling” can come either in the form of promises to pay, i.e. bank loans or corporate/government bonds, or in physical assets like commercial or residential real estate or manufacturing plant and equipment.

…isn’t sustainable forever

This situation can’t go on forever.  If nothing else, at some point country A will run out of assets that country B will desire to buy.   In our simple world, country B will then be piling up loads of $ that it doesn’t particularly want.  Initially, it will “recycle” extra $ into country A’s bonds to get some interest income.   But there’s a limit to that, as well.  Sooner or later, the debt will reach a level where country B will get worried about the possibility that A may not be able to repay.

The level of country B’s concern will depend to some degree on its analysis of the character of A’s economy and of its imports.  If country A is importing, for example, machinery it will use to develop new export-oriented or import-competing businesses, B will be less worried.  So, too, if it sees that some purely domestic industry has immense potential to develop into an exporter.  But if the imports are mostly of consumer items that will generate no future income–like TVs or building materials for McMansions–concern will rise a lot faster.

In any event,  a persistent trade (and current account) deficit will sooner or later cause downward pressure on country A’s currency.  Country B will demand a premium for continuing to hold $.  What happens then?

intervention

One possibility is that country A intervenes in the currency market to buy up the “extra” $ that are sloshing around.  That is, the government of A takes action to defend the $1 = @1 exchange rate.  It may also have help from country B in doing so, since the government of B may be satisfied with the status quo.  In the real world, this is not a good solution, since the big international commercial banks, who would be the most worried about the present situation and who may well be leading a trading attack on the $, have far greater market power than any set of governments.

Two possibilities remain–external structural adjustment or internal structural adjustment.

Internal adjustment means slowing down the purchase of imports, particularly of imported consumer goods.  In practical terms, this means the government raising interest rates and inducing a recession.  How so?  The problem country A faces is typically that government economic policy is too stimulative.  As a result, the country is living beyond its means.  Most of the “extra” economy energy is going into consumption, and a disproportionately large share of that is going into consumption of imported goods.

The practical issue with internal adjustment is that politicians find this very difficult to do, since the change in economic policy is very visible.  It’s also very clear to voters exactly who has taken away the punchbowl.

External adjustment means standing aside and letting the currency markets achieve a new equilibrium.  In other words, in our example, country A allows the $ to devalue to what is, for now anyway, a new equilibrium level.

This is the solution almost all countries opt for, even though it leaves internal structural problems unaddressed.  Why this path?  It’s easier politically.  Local citizens will likely not realize the large loss of national wealth that devaluation entails–unless they travel abroad.  And to the degree that citizens do notice that the local price of imported goods has increased, anger can easily be directed against “greedy” currency speculators or foreign industrialists.

In academic theory, adjustment through currency devaluation is an illusory process.  The economy reverts to its prior state of disequilibrium, only with inflation at a higher level.  For smaller countries, I think that this is true in reality as well.  In the case of large countries like the US, the reality is more complicated.  More about this in later posts.

A 2010 equity portfolio: what I think it should look like today

January 8, 2010 By in Shaping a portfolio for 2010, Strategy Tags: , , , , , , , , 2 Comments

Before we start, remember what we’re trying to do.

We’re not trying to analyze (much less solve) all the world’s problems.  We’re not trying to have a lot of opinions about different stuff.

We are trying to figure out what the most significant factors influencing stock market performance will be this year.  We’re going to divide these factors into ones we have very strong conviction about–or, alternatively, ones we want to build into your portfolio–and the ones we don’t.

Then, we’re going to construct a portfolio that will outperform if the things we have the strongest conviction in turn out to be correct.  At the same time, to the extent that we can, we’re going to neutralize (index-weight) the areas where we’re relatively clueless, so that we don’t get hurt by fooling around with things we don’t know much about.

Here’s what I think: Continue reading →