Weekly unemployment claims were not disappointing

Interpreting economic data is an art, not a science, unfortunately. Some people can look at the top chart of seasonally adjusted jobless claims and see that claims remain at relatively high levels historically, they haven't fallen below 400K per week for 18 weeks, and this means the economy remains in terrible shape. Others can look at the bottom chart of non-seasonally adjusted claims and see that they remain in a downtrend, the most recent datapoint was the lowest since September, 2008, and this means that the economy continues to slowly improve. I'm in the latter camp, but given today's equity market rout, the bears appear to be in charge.

Understanding the rise of the yen

This morning in Japan, the yen flirted briefly with—yet failed to reach—a new record intraday high against the dollar (highest value to date is 76.25 on Mar. 17th of this year), thanks to forceful intervention by Japanese authorities. The yen and the Swiss franc have both been the beneficiaries of investors' concerns over the health of the U.S. economy and the prospect that the Fed, with the consent of Treasury, may seek a further depreciation of the dollar (which decline would supposedly boost the economy) by resorting to another round of quantitative easing.

The chart above seeks to put the yen's recent ascent against the dollar into the proper perspective, by comparing the yen/dollar exchange rate to a theoretical purchasing power parity exchange rate (which is calculated to equilibrate prices between the two countries). The reason that both the PPP and the actual value of the yen have been rising vis a vis the dollar is easily explained by the observation that inflation in Japan has been much lower than inflation in the U.S. In fact, Japan's CPI has not changed on net for the past 18 years, while the U.S. CPI has increased by about 56%. This rather large inflation differential would, by itself, explain the entire appreciation of the yen and then some. That's because the yen/dollar exchange rate needs to rise by the same amount as the U.S. - Japanese inflation differential in order to keep prices in the two countries from diverging. Put another way, higher U.S. inflation tends to produce an eventual weakening of the dollar vis a vis the yen, otherwise U.S. prices in dollar terms would rise relative to Japanese prices when converted to dollars.

Relative to its PPP, the yen is "overvalued" by almost 50% against the dollar. That means that the typical American tourist likely will find that prices in Japan tend to be about 50% higher than comparable prices in the U.S. The exchange rate market is willing to pay a premium for the yen in order to enjoy the virtues of its stable purchasing power and escape the ongoing decline in the value of the dollar. By comparison, I calculate that at the current exchange rate of 1.43, the euro is about 25% overvalued against the dollar, as can be appreciated in the chart below. European inflation has been only slightly less than U.S. inflation in the past 18 years, so the euro doesn't merit as much of a premium as the yen. That the euro is still trading at a premium, despite the ongoing and very real threat of a substantial restructuring of PIIGS debt, suggests that the market doesn't believe an ECU sovereign default will threaten the ongoing viability of the euro. By extension, it also suggests that the ongoing viability and purchasing power of the dollar is a risk to be reckoned with.

A weak dollar—which is undervalued on a PPP basis against almost every major currency on the planet, and whose real, inflation-adjusted value against a large basket of currencies is at or near an all-time low—has many unpleasant implications for the U.S. economy. For one, it means that foreigner's desire to invest here is weak, which is another way of saying that capital is expected to be more productive elsewhere. Two, it means that the purchasing power of all U.S. residents has been reduced significantly should a resident venture outside our borders. Third, it tends to put upward pressure on the price of all imported goods and services. Fourth, it encourages U.S. firms to raise the price of their exports, since otherwise they might be very cheap to foreign buyers. Fifth, if higher export prices hold, it then encourages firms here to raise their prices domestically. Sixth, it encourages foreigners to buy goods and services here in the U.S., particularly real estate which happens to be very cheap on its own merits. Finally, if the dollar sustains these low levels for long enough, inflation is bound to rise, thus undermining the purchasing power of all U.S. residents.

Some argue that a weaker dollar would strengthen the U.S. economy, but the arguments in favor of that proposition are notoriously weak. A weaker dollar might provide a temporary boost to export-oriented industries, but it would also tend to provide a more lasting boost to the prices of all imported goods and services, thus raising costs for everyone. Competitive devaluations in the end are a fool's game, and it can be said with some justification that no country has ever devalued its way to prosperity.

As a supply-sider, I have learned that it is very important to pay attention to market-based signals, since they can provide very good and timely information about the fundamentals of our economy and our financial markets. Currently, it's hard to find anything that is pointing in a healthy direction. And that is why I remain optimistic, because the world appears to be uniformly and profoundly pessimistic about the prospects for the U.S. economy, while I still hold out hope for improvement. For example, while the recent debt limit accord was far from perfect, it was a step in the right direction. And while the Tea Party is being painted as "terrorists," I believe they have the country's best interests at heart, and they will undoubtedly redouble their efforts to enforce some degree of fiscal sanity on Washington in next year's elections.

Thoughts on inflation and growth

This chart shows the 6-mo. annualized rate of change for the headline and core versions of the Personal Consumption Expenditures Deflator, the Fed's preferred measure of inflation. Both measures of inflation now equal or exceed the Fed's professed inflation target of 1-2% on the core measure of inflation. Note also that both measures exceeded the Fed's target most of the time from 2004 through 2008. That period, of course, was one in which the Fed pursued very accommodative monetary policy because the economy was perceived to be relatively weak and deflation was thought to be a threat.

As I mentioned last week, the GDP revisions that resulted in lower growth and higher inflation must have come as quite a surprise to the Fed, especially since the Fed holds to the theory that very weak growth (and growth well below potential) should result in lower, not higher inflation. Now, not only has inflation turned up when it should have turned down, but the Fed's understanding of what makes inflation tick has been called into question once again.

This is not to say that we have an alarming amount of inflation on our hands, because we don't, at least according to the official inflation statistics. The important thing here is that the Fed's theory of inflation (aka the Phillips Curve theory of inflation) has not done a good job of predicting or controlling inflation. Meanwhile, the classical theory of inflation—that it is fundamentally a monetary phenomenon and has nothing to do with how strong or weak the economy is or whether there is a lot of resource slack or not—has done a much better job. There has been abundant evidence for some time now that the Fed was being too accommodative by supplying more dollars to the world than the world wanted. The evidence has been in plain sight, and supplied by market-based indicators: the very weak dollar, the rising prices of gold and commodities, the very steep yield curve, and the rise in inflation expectations as embedded in TIPS prices.

The classical view of inflation says that as long as the evidence points to a surplus of dollars in the world, then inflation will tend to move higher. So once again I conclude that investors should pay more attention to the risks of higher inflation rather than to the risks of deflation. That translates into a preference for asset classes with exposure to rising prices, such as equities, real estate, and commodities. At the same time, it argues for extreme caution in regards to Treasuries, especially since they are trading at very low yields. Treasuries have done very well of late, but that is not a reason to like them, since the lower yields go the more than prices stand to fall in the future if inflation does indeed move higher.

Finally, this analysis also suggests that the Fed is going to find it very difficult to justify another round of quantitative easing. There's too much inflation and too much uncertainty right now about where it's headed (did I mentioned the huge increase in the volatility of inflation in the past decade that is evident in the chart?) for the Fed to risk another massive easing effort. The economy is not at all starved for liquidity; there is plenty of money out there.

What is lacking is the willingness of investors and corporations to risk their money in the pursuit of new and productive ventures. There's not enough confidence in the future, there's too much concern about increased regulatory and tax burdens, and there's too much concern about the future value of the dollar. When those concerns subside, new investment and stronger growth should follow.