October 26, 2010
Yes, We Have InflationBy Stephen Mauzy
Deflationphobes rest assured; deflation remains a bluff. The September Producer Price Index showed no sign of price deflation. Over the past twelve months, the PPI has bubbled up a frothy 4 percent, while the Consumer Price Index has leavened its year-over-year tally 1.1 percent (and yes, food and energy are included; price volatility is no excuse for exclusion). Contrary to government semantics, an increase is still an increase even if it fails to meet previous expectations.
But is it enough of an increase? Some think not. Federal Reserve Chairman Ben Bernanke recently opined, "Inflation [consumer] is running too low. It is too close conceivably to the kind of tipping point into a deflationary environment." Bernanke set the tipping point at "2 percent or a bit below."
Strange that the Phillips Curve, buried in sophistry and shame during the stagflationary gloom of the 1970s, should be reconstructed as the foundation for modern monetary policy. Stranger still is the inextinguishable belief that consumer-price inflation is synonymous with prosperity. One of the more prosperous epochs in U.S. history -- 1866 to 1900 -- was highlighted by falling consumer prices (what cost a dollar in 1866 cost $0.57 in 1900) and raging real GDP growth (GDP quadrupled over the same 34 years).
If the deflationphobes insist on a fight, perhaps they will temper their pugnacity knowing that inflation is more than prices. In fact, inflation isn't even prices: inflation is an increase in money supply. This simple fact reveals the absurdity of the term "inflationary pressure." Either the government and banks are inflating the money supply or they are not.
They are inflating. By all appearances, the Federal Reserve has co-oped Doritos's memorable advertising motto -- "eat all you want, we'll make more" -- by printing all the money we insist on saving and then making more. But money isn't tortilla chips: Besides serving as exchange media, money serves as a store of value and source of sustainable investment capital. Unlike increased Doritos production, increased money production doesn't benefit consumers; it devastates the value of productively generated savings instead.
The high priests of the Federal Reserve think otherwise. The Board of Governors Monetary Base is $2 trillion, a $1.2-trillion increase over 2008's $800 billion; M2, the more inclusive money-supply measure, bobs about at $8.7 trillion, an all-time high; and excess reserves of depository institutions stand at $980 billion, an incalculable increase from zero. Should Keynes's famous animal spirits kick in, and should the Federal Reserve cease paying interest on excess reserve deposits, another $9.8 trillion of potential new money is theoretically in the waiting (and a possible ten times more than that if it's high-powered money).
Despite being awash in liquidity, individuals and businesses remain circumspect. Businesses sit on $1.8 trillion in cash and cash equivalents while the personal savings rate stands at 5.8 percent -- a hoarding percentage compared to the animal-spirited mid-2000s, when the personal savings rate averaged between 1 and 2 percent (inspiring a few Federal Reserve monographs, including one with the obligatory alarmist title "Should the Decline in the Personal Saving Rate Be a Cause for Concern?").
With money in ample supply, why, then, are consumer prices subdued? Money is one of many variables determining consumer prices: productivity, supply and demand for goods and services, changes in product quality, and technology matter as well. Money demand is particularly randy these days because of soaring uncertainty related to the ugly reality: cap & trade, Dodd & Frank, ObamaCare, swelling deficits, and new taxes. We can only imagine what ugliness lurks over the horizon.
The Federal Reserve has created a tremendous amount of money, to be sure, but the money has disproportionately flowed into financial markets (particularly equity markets) instead of into the real economy. By deflating government bond yields (and pushing up prices) through open-market operations, the Federal Reserve has created capital gains for government bondholders. Concurrently, the Federal Reserve has made equities appear more attractive compared to bonds (based on earning yields and bond yields), thus producing a surge in equity investment.
The rally in equity prices is really an extrapolation of a longer-term trend. Over the past eighty years, the stock market value as a percentage of GDP has averaged 62 percent. For the first sixty of those years, the stock market traded mostly within a 30-percent-to-50-percent band. It first plotted above 100 percent of GDP in 1996. It's been below that level only twice since, following the internet and housing busts of 2000 and 2009, respectively. After dropping to a low of 71 percent of March 2009, stocks have returned to the contemporary norm of over 100 percent of GDP.
So much money flowing into the stock market has produced persistently high stock-market valuations. The ratio of stock prices to stock earnings (P/E ratio) for S&P 500 members now averages about 20, whereas it used to average around 12. What is more, because so much money exists, the P/E ratio of S&P 500 stocks no longer bottoms to single digits when the extent of the previous boom's malinvestment is realized, with 1984 being the most recent year the S&P 500's P/E ratio dipped to single digits.
Cavalierly interpreting correlations as causations can deceive, but deductive reasoning suggests a causative relationship between money supply and asset prices. If the quantity of money were static, the overall level of asset prices should remain static as well. (Stock market indexes owe their persistent appreciation to inflation.) In a static-money world, capital gains could be achieved only through asset selection -- by investing in promising companies to the detriment of lagging companies. In our inflation-centric world, most stocks -- good and bad -- rise during inflation-fueled binges.
Of course, there are consequences to asset-price inflation. New money funneled into assets means less money funneled into GDP, which further frustrates and emboldens the Federal Reserve to inflate even more. When money is created via bank loans to business, the money further distorts the pattern of productive investments, producing even more malinvestment that will invariably lead to an even more painful correction down the road.
So we have both monetary inflation and asset-price inflation at this juncture. Consumer-price inflation is in the waiting (which, anecdotally, we all know has arrived). If the Federal Reserve persists in inflating the money supply to the point where assets no longer soak up the overrun, the excess supply will flood consumer-goods markets as the public attempts to recoup its command of economic resources by raising prices to the speed of new money creation. Should that occur, consumer-price inflation will tip from a "desirable" pursuit into a viral pandemic; then we'll really have something to be anxious about.
Update: The latest Treasuery auction of inflation-protected bonds has sold at a negative yield, confirming the markets expect inflation. [Hat tip: Michael Geer]
Stephen Mauzy is a CFA charterholder, a financial writer, and principal of S.P. Mauzy & Associates. He can be reached at firstname.lastname@example.org.