At least not in the stock markets… that may indeed turn out be this week's trepidation as the ticker tape action of the various superficial "Safe Havens" fired up last week. But first, I would like to discuss an Inflation breakout, which I see so very clearly encroaching upon our horizon. I see it as inevitable as the morning sunrise, and there is plenty of evidence to suggest that the argument is getting stronger.
Seven Reasons why the Fed is in an Inflation Trap
Reason #1; "The Sponge"
In order to avoid inflation and actually have deflation, the Fed is going to have to soak up all the excess dollars whose speculative utility suddenly evaporates, but whose residual liabilities do not. I don't think that many people really understand the implications for interest rates under a project with such magnitude as that. A recession would not be enough to prevent inflation; the project would require a forced depression. The reason is that a recession would likely bring with it some form of what conventional economics calls stagflation, the onset of which would probably arise from a weak exchange rate. The Fed would be required to give up trying to balance growth with monetary discipline entirely, and get tough enough to do what Paul Volcker eventually had to do.
Right. From man of the year to the bum who threw out the Plaza Accord, all in the span of maybe one term… it takes quite the character to do the right thing while every man, woman and child in the country say he is wrong to take their livelihood away from them… even if it was illusory to begin with. So before you accept that this kind of resolve exists, consider that Mr. Greenspan's anecdotal assurances of structural productivity gains are conveniently supportive of the Fed's easy money policies. That being said, anything less than pure "resolve" will result in a weak currency and continue to manifest in dollar inflation.
It is conceivable that had the Fed any aspiration for accountability (facing a similar predicament in 1971) when Nixon broke the dollar/gold link, the Bretton Woods system possibly could have survived. Instead, they chose to let the dollar float, which astonished populists who actually thought it would rise in value, vis-à-vis the gold price.
Reason #2; See no evil, hear no evil…
We have already had inflation for two years now and people still do not recognize it for what it is. I spoke about this last week, where many analysts interpret the oil crisis as a supply/demand problem rather than an inflation problem. Already I see talk that higher oil prices equal an economic slowdown, which equals easier money policy. While the verdict is still out on whether there really is a supply/demand imbalance in the oil business as great as the market suggests, the inflation worsens. The government is trying to put a band-aid on this deterioration in purchasing power by releasing partial supplies of its strategic petroleum reserves, but all this does is buy them some time.
|Commodity Research Bureau Index ||Goldman Sachs Commodity Index - T/R |
It is this denial of the obvious erosions of purchasing power in the dollar, which will turn out to be inflationary in the end. Yet there is a paradox here. The point at which inflationary money policies are recognized for what they are is the point at which the inflation accelerates. This is the inevitable point that the Fed must try hard to delay.
Reason #3; Speculative Psychology
There was a time where tighter monetary policy proved good for the currency's purchasing power, internal and external. No longer… currency speculators have been trained to hammer the currency whose central bankers bestow upon it a weaker economy. Each time that the Fed, ECB, or BOJ deliberate on higher interest rates today, they must consider the impact on their currency's exchange rates.
I believe that the credit cycle is so extended (over leveraged) now, that the ability for any monetary authority to contract the money supply in order to prevent inflation has been compromised. That is because the new psychological phenomenon, of how tighter monetary policy (higher short term interest rates) deliberations affect currency markets, is inherently inflationary. The reason is that central bankers may hesitate on the need to raise interest rates if they fear that currency players will punish their currency for not promoting growth, rather than pursuing a sounder money policy.
This is the market saying that it will not tolerate sound money at the expense of growth. It is the market forcing inflationary policies. Increasingly, the relationship between growth and stability has become as mutually exclusive as gold and paper. It wasn't always this way.
Reason #4; the vested interests of a debtor nation
Because the United States has become the world's largest net debtor, it is no longer in its economic interest to foster a sound currency policy. This might sound difficult to believe but it is logical to presume that it is in the interest of a debtor nation to ruin the currency value of its debt, if it has to choose between inflation and depression. For at least with inflation, there is the illusion of profit while it (the inflation) is containable. This topic is covered in Inflation versus Deflation.
Reason #5; who controls Money Supply
The role of money creation no longer rests with the Federal Reserve, but has been transferred to financial intermediaries on Wall Street who have spun it into a monumental credit bubble and asset price spiral. The conspicuous decoupling of the broader monetary aggregates (M3) from the monetary base needs to be explained. Consider one explanation.
Since the Fed has pursued tighter monetary policy for nearly a year and a half, you would expect to see little growth in money supply. Indeed, the growth in M1 (currency in circulation + demand deposits) has been stagnant for five years now. However, the total supply of money is not managed by the Fed, only interest rates are. The private sector is free to create as much credit as it can at that rate provided that it has adequate reserves. Now here is where the real questions are.
I discussed the Capital Adequacy issue briefly in the spring, when central bankers were running around the world negotiating the new standards proposed by the Basel Committee with important private banking groups. To sum it up, it was recommended that the banking sector determine its own guidelines as to determining the creditworthiness of their clients, thus determining their own capital requirements. Guess who won that one? There is reason to believe that banks are not adequately capitalized against a downturn. And there is reason to believe that they have been inflating, securitizing, and monetizing enormous amounts of low quality debt, which they in turn buy back in the money market (to a smaller degree) after it has been assigned an adequate credit rating. If this is true, then it is likely that the money market debt they include in their capital base is inadequate capital.
What is the value of a currency whose creators find it expedient to stave off default simply by providing their clients with more of it?
Reason #6; the Politics of the Dollar
The interests of the global powers are beginning to change. Financing the US trade deficit is proving to be an increasingly inflationary prospect for European bankers as they have had to maintain money supply growth rates above target in order to facilitate it. The exchange rate has begun to suffer as a result. Japan, already having learned its lesson has begun to explore the positive economic benefits achieved with a strong currency. The strong dollar policy has become increasingly at odds with both growth and globalization (this will become more apparent when growth slows, and nationalistic labor markets bemoan the export of jobs).
Should the US dollar exchange rate begin to reconcile with these changing political interests, one must remember that the corrective forces resulting form the current trade and exchange rate imbalances are inflationary.
Reason #7; a decline in marginal utility
The principal utility of the dollar has been for global consumption and speculation, both of which are tired, structurally! The US consumer's propensity to import has been the foundation for the foreign propensity to invest. It is not an independent correlation. When this relationship stops, excess dollars may show up everywhere, first on foreign exchange markets and then in terms of deterioration in internal purchasing power. Even as a hoarding mentality initially develops, so long as there remains a choice between inflation and deflation humans will choose to inflate. Labor will demand more money and the Fed will give it to them, for fear of retribution. For it is the lender of last resort and labor is last in line. Inflation is the path of least resistance and the lender of last resort model in the hands of a net debtor ensures it.
There is still too much hope
"If you bought Intel at $75 only one month ago and you bought it for a 10 year outlook, then NO, do not sell it down here at $40... only a month later." -Mr. Altair Gobo, CFP US Financial Services, responding to an inquiry about the investment merit of Intel shares on CNBC last week.
What if you didn't buy it for a ten-year outlook? WHO PAYS FOR THIS ADVICE? First of all, who the heck has been buying any kind of stock for longer than a six-month play in this market? Are they telling us that the average buyer at $75 was looking out ten years... at a record earnings multiple and in a volatile sector? Perhaps now by default they will be, especially with encouraging advice like this. More like he or she was hoping to make some easy summer money trading a stock tip. The fact is that s-o-o-o-o many things can happen over ten years. Ten years ago, I couldn't find a soul to buy a mutual fund. Can you believe it? Ten years ago, Al Gore was yet to invent the Internet. Still, if you were buying it at $75 thinking it would be a good ten year hold and it is trading at $40 one month later, shouldn't it be a better buy today. Don't ask Mr. Gobo, he squirmed a little when asked if Intel was a buy today.
So what can be made of all the earnings warnings of late? Maybe we got all the bad ones out of the way as the companies that were going to have any earnings trouble have already come clean, and the market is now set to go because whoever is left must have good earnings. Avoid this dangerous assumption... it is only a coin toss. Psychology such as this has to capitulate before a bottom is really in place. In any case, this quarter's earnings announcements are irrelevant to the future course of the stock market because the Equity Risk Premium is too low. There are still more than a few adjustments that need to be made, and judging by the way that the market rolled over on Friday, perhaps they will be made this week:
|American Express Co ||AMEX Broker/Dealer Index |
|AMEX Biotechnology Index ||AMEX Networking Index |
|AMEX Computer Technology Index ||Philadelphia Semiconductor Index |
The bulls have really got one shot at responding to Friday's capitulative sell off. Barring that, look for another timely intervention in the Dollar/Euro or energy markets, though that may turn out to be a bad move if the inflation data on producer prices comes in unexpectedly strong. A sure sign of desperation and inevitably, an inflationary outcome.