Monday, May 3, 2010

One reason inflation remains tame: strong money demand

According to the Personal Consumption Deflator, the Fed's preferred measure of inflation (and a pretty decent one, I might add), inflation with or without food & energy remains within the Fed's target range.

Note, however, that inflation from 2004 through most of 2008 was consistently above target, and I think I know why. This period was preceded by all of the conditions that I have been worrying about for the past year. The Fed adopted a very accommodative monetary policy starting in late 2001, holding short-term interest rates below 2% through late 2004; gold prices rose from $260 in early 2001 to over $400/oz by late 2003; the dollar lost over one-fourth of its value against other major currencies from early 2002 to late 2003; commodity prices rose almost 60% from late 2001 to late 2003; and the yield curve went from being flat in early 2001 to almost as steep as it is now by late 2003. I consider that all of these signs are good leading indicators of rising inflation, and we have seen every one of them repeat over the past year or so: the dollar has fallen, gold has surged, commodity prices have surged, the yield curve has steepened, and the Fed has been holding short rates at almost zero for 18 months.

The one thing that is different this time around (history never repeats itself exactly, of course) is that for most of the past year or so the public's demand for money has been exceptionally strong. We saw the evidence of that in the big decline in velocity that occurred from late 2008 through mid-2009; in the big increase in currency in circulation and in M2 that occurred from late 2008 through March of last year; in the widespread signs of deleveraging in corporate America and among households from late 2008 through today; and in the very weak growth of bank credit.

In short, monetary policy has been exceptionally easy for the past 18 months, but the public's demand for money has been exceptionally strong at the same time. Monetary policy is inflationary only when the supply of money exceeds the demand for it. This is the essence of my rationale for why measured inflation hasn't yet increased, even though my favorite leading indicators of inflation are all pointing up: the Fed hasn't oversupplied money by enough to overcome the disinflationary aftermath of sudden and unexpected shock to confidence, a significant slowdown in economic activity, and the inflation "inertia" of the massive U.S. economy.

I note that rising inflation is now showing up in many Asian countries, and particularly in China. Most of them have effectively outsourced their monetary policy to the Fed by effectively pegging their currencies to the dollar. If U.S. monetary policy is inflationary, then it would makes sense that inflation would show up in smaller and less developed economies long before it showed up in the U.S. economy.

I think it is also worth highlighting the fact that despite the depth and severity of the recent recession, and the huge degree of "slack" or idle resources that have existed for most of the past year or so, there are no signs yet of deflation. The deflation that was predicted by popular (e.g., Phillips Curve-based) models of inflation was a total no-show. Recall that at the end of 2008 the bond market—via the mechanism of TIPS' breakeven spreads—was predicting significant deflation for years to come, yet instead we find that inflation has been running at a 1-2% rate for the past year.

In any event, and as Milton Friedman taught us, the lags between monetary policy and their impact on the economy are long and variable. That measured inflation hasn't risen yet, despite aggressively accommodative monetary policy and the appearance of a host of leading indicators of inflation, is not a reason to cheer. Investors can't wait for the signs of inflation to become obvious, since by then it's too late to react.

Prudence, a focus on the monetary nature of inflation, and a quick glance at the Fed's massively bloated balance sheet (which the Fed admits may take many years to reverse) should be enough to convince investors today to worry much more about inflation than deflation. That in turn should leave one more optimistic, not less, about the future prospects for growth in the U.S. economy (since the appearance of deflation could definitely weaken the economy, aggravate the burden of everyone's debt, and increase default risk), and it should make inflation hedges more attractive, not less. It should also argue against holding cash or cash equivalents.

Full disclosure: I hold no cash or cash equivalents, am long TIPS, long a variety of equities, long high-yield debt, long emerging market debt, and short Treasury bonds (via a 30-yr fixed rate mortgage) at the time of this writing.


Steve said...

is it possible the figure describing the value of goods exported will rise, causing the spread between nominal and real export values to increase, as those exports will surely be commodity rich? If true, what does it say for the prospects of the service sector?

Benjamin Cole said...

Even some inflation won't hurt.

Property owners could use the help, and (for now, anyway) since we pay international debts in dollars, inflation just decreases our debt outstanding.

I see little hope of the federal government running surpluses any time soon, so some inflation would "pay down" the federal debt as well.

Inflate away, I say. I hope Grannis is right, and some inflation is inevitable.

I happy to learn we did not have deflation. I will explain that to prospective tenants for small industrial space that I own in Los Angeles, who used to be happy to pay $1 a square foot, and now get it for 65 cents--if I can find the tenants. Perhaps I will refer them to this blog.

Cabodog said...

Inflation will be the only way to save municipalities and states. Given the current pressure to either freeze or reduce wages and benefits, governments will welcome any inflation, which will allow private sector wages/benefits to equalize to those in the public sector.

Inflating revenues, earnings, wages of the private sector will increase revenue for the government, which when combined with frozen or reduced wages/benefits, will solve a very nasty current situation.

I'm sure Washington is very aware of this and will err on the side of inflation.

Bill said...

Benjamin: Declining rents, by themselves, are not proof of deflation. As Scott has explained previously, deflation is a general decline in prices rather than declines in just a few sectors. The decline in rents is a function of the bursting of the property bubble rather than a sign of generalized deflation.

By the way, I too have suffered with declining rents with my residential properties. But, prices elsewhere in the economy are now rising and rents have stabilized. So, I anticipate that rents will begin to rise noticeably within the next 12 to 18 months.

CFP, EA said...


Glad to see that you're incorporating the 30-fixed mortgage as part of your portfolio. I like how you describe it as shorting bonds.

Of course, it has one big difference: Unlike a short, if interest rates fall, you don't lose money; you simply refinance and start the short all over again, except in a better position.

By the way, hope you enjoyed your trip to Loudoun County and Middleburg. I live about 10 minutes north in a much less picturesque town. The area may not be the California coast, but it's not bad.

Scott Grannis said...

CFP: You're very right about the virtues of 30-yr fixed rate mortgages that can be had at some of the lowest rates in history. Most people are probably unaware of the fact that the implicit price of the refinancing option is very low, so low that it is almost like having a free put option.

Public Library said...

You've got a bunch of technocrats playing 'pull the lever' on a scale not seen before and none of this is cause for alarm to you guys. Furthermore, everyone in-charge has made massive mistakes in the not so distant past.

The number of quotes from Bernanke misdiagnosing the economy would be comedy if he wasn't leading the mother-ship right now.

Talk about myopic view points. Me-o-my-o-me

Benjamin Cole said...

Of cxourse, I realize that rents for small industrial space in L.A. are not the whole economy. It is an anecdote (although I think it's even softer for larger industrial space).

However it, is a telling anecdote--it is the cost of business I am talking about.

Rents are down for office, industrial and all commercial space. Crickey, you practically have to give the stuff away.

That will flow through to lower business costs. Add that to soft wages, good productivity gains and lots of competition in all sectors for everything.

In my litle corner of the world, we saw serious deflation. I was close to property markets, both as landowner and in some business lines such cabinets, furniture, architecture. In my lines of work, we saw business cut in half. It wasn't a recession, it was and is a depression.

The onyl good news is that if you are still standing the climb back looks long and good. I hope.

Redbud said...

My guess is that the fed can't pour it in fast enough to keep up with natural deflation. Otherwise, their "balance sheet" would have had us in a ferocious hyperinflation by now.

Benjamin Cole said...

Here is an interesting fact: In yen, gold is half the price (even nominally) that it was in 1980.

That means after 30 years, a Japanese buyer of gold has half of his investment left (assuming no storage fees etc.) In nominal terms he is a 50 percent loser.

in real terms, no doubt, the picture is even worse.

What does this say about the Japanese money supply? The yen has appreciated against the dollar in the last 30 years.

BTW, the Japanese are now net sellers of gold, and the Chinese are the world's biggest buyers.

Scott Grannis said...

Benjamin: the incredible strength of the yen against gold and all other currencies is the primary reason Japan has been plagued by deflationary forces for many years. The Bank of Japan has been overly restrictive in its policy actions for decades. This is evidenced clearly in the fact that the Japanese Monetary Base has grown by only one-third as much as the US Monetary Base since 1980. The supply of yen has been greatly restricted over the years in comparison to the supply of dollars, so it is not surprising that the value of the yen has risen by about 350% versus the dollar.

Unknown said...

Scott, can you expand a bit more on your description of inflation indicators being held down due the 'demand for money' that makes this period different than 2001-2003 ? Maybe its own posting? Both the theory and the indicators. Thanks.

Scott Grannis said...

Jeff: Inflation is the result of an excess of money supplied relative to the demand for it. The Fed is clearly willing to supply an almost infinite amount of money to the system. But the system is apparently willing to demand much more than anyone might have expected. Very strong money demand (as reflected in a huge decline in money velocity from Q3/08 thru Q1/09) thus largely neutralized the otherwise-inflationary power of a huge increase in money supply.

I'm reminded of the S.E. Asian currency crisis of 1997. With all currencies collapsing against the dollar, the world's demand for dollars was gigantic. The Fed failed to offset this rising dollar demand with an increased dollar supply. In fact, the Fed continued to raise rates to tighten money supply. The result was commodity price deflation, the 2001 recession, and a dangerous flirtation with actual deflation in 2002-2003.