Aug 1 2008 12:51PM
Which inflation is it, anyway?
There is a debate building around inflation. The outcome of this debate will determine the direction of interest rates and credit creation. By extension many commodity prices, especially precious metals and energy, will get direction too.
This past week saw the release of the US CPI reading for June with a “headline” increase of 1.1%. Even the much derided “no heat-no eat” Core Rate that excludes food and fuel was up 0.3% for the month. The 12-month CPI gain in the US is now 5%, and even a sustained pullback in oil prices won’t cause consumer inflation to retrench much this year.
CPI is the only inflation measure many people ever focus on even though it is so heavily massaged it borders on fiction. Nonetheless, that is the headline number and the one that consumers are supposedly thinking about as they wonder what sort of wage increases they need to keep up. Likewise, businesses watch the number closely, and try to plan ways to pass on cost gains without losing customers. Left unchecked, that sort of thinking could ultimately lead to a wage/price spiral that no one who lived through Paul Volcker and his G7 colleagues wrestling inflation to the ground in the late 1970s wants to revisit.
As important as the CPI number is to perceptions of inflation, many gold followers may now find themselves in something of a predicament using it gauge future price moves. Most fans of the yellow metal are, implicitly or explicitly, of the monetarist economic camp. They view changes in the supply of fiat currency as the determining factor for changes to inflation. Taken further, hard money monetarists view all fiat currency as ultimately doomed stores of value - politicians and bureaucrats will always fall back on the printing press when times get tough and thereby erode the value of that currency. An ever expanding supply of fiat currency chasing the same basket of goods means prices will inevitably be bid up, at least as measured in that fiat currency.
Milton Friedman, free marketer and champion of the monetarist view, put it most succinctly when he stated that “inflation is everywhere and always a monetary phenomenon”. We’re not sure that is true, but if it is, that still leaves some complexity in deciding what “money” is.
Monetarists have different views on which money supply figures matter, and often disagree violently on the import of statistics. Nonetheless, few would argue that the changes in “narrow” money supply (M1 and M2) over the past few months speak to a scary trend, though a different one than you might have read in the headlines. In the US, M2 (cash, current account deposits, and short-term savings deposits) began falling off a cliff earlier this year. Growth in M2 spiked earlier in the credit crisis, reaching16% near the end of the first quarter. It has since reversed course with a vengeance - M2 contracted in the latest month.
Each month brings more negativity in the banking sector and tighter lending conditions. Changes in bank credit, a broad proxy for lending and money supply changes make for grim reading lately. Those too have dived, going from a growth of 12% last year to an 8% contraction (so far) this year. If you can’t borrow, you spend what you have, and “what you have to spend right now” would be another way of defining M2.
This 8% contraction in bank credit is the steepest fall for it in 40 years. This doesn’t bode well for growth figures given credit creation (lending) in a fractional banking system is a main conduit for money creation. The underlying cause of the contraction is, presumably, that banks are worried about having even the fraction of deposits required of them to be considered solvent.
Some monetary purists, we know, will point to the broader M3 measure (which the US no longer publishes) that rose rapidly last quarter. We think observers that view the recent surge in this measure as temporary are right. Most of the growth probably represents companies fully drawing down lines of credit before the banks cut back on them. It’s not “new” lending in the strict sense of the word, and does not therefore represent new stashes in longer term accounts being put to use.
So what does one make of a situation like this? On the one hand, headline inflation is rising rapidly. On the other hand, you would be hard pressed indeed to find an economy that managed to grow through a period when credit was contracting at the speed it currently is. There are still plenty of inflation hawks out there, including a number of US Fed Board members. The ultimate hawk these days is Jean Claude Trichet, head of the European Central Bank, but money supply growth is diving in Euroland too.
We’ve never pushed the money supply aspect too hard ourselves. We haven’t found it was a great predictor of price inflation, even though monetarists would tut-tut and argue those money supply growth rates are inflation. Big changes in money’s growth rate, like the one currently taking place, do tend to be significant however. That’s why monetarists were among the first to scream “fire” while most were still congratulating Greenspan for the low lending rates that helped create the housing bubble.
The contrary view from assets…
In order to make sense of the current situation you have to look at assets as well as consumption. In addition to rocketing CPI, this is also a period of collapsing asset prices in large part generated by the backlash from that housing bubble. The question for markets is which set of price changes should it be responding to?
Based on the unprecedented scale of asset price falls we think there is little doubt they will trump headline inflation numbers. We don’t see how the uptrend in consumer prices continues when the falling value of nest-eggs has to be generating widespread demand destruction. The evidence that price inflation is spreading, to be expected when energy costs that underlie most goods creation are a large part of the primary inflation, is likely the end of game of this inflationary round playing out. With unemployment in the US rising it is difficult imagine wage increases gathering steam. Wage-pushing higher in response price gains has always been the mechanism that imbeds higher inflation and makes it so hard to control. Europe, with stronger work laws and higher unionization has more potential for wage inflation, so perhaps Trichet can be excused for his hawkish stance.
In the face of these forces, and the dropping money supply figures, there is only one likely response. Bernanke is a student of the Depression and most agree that credit contraction at the wrong time helped to create and prolong that disaster. Banks are so reluctant to lend right now that we can’t imagine Bernanke adding to the misery. He’s going to keep the lending lines open and there is little chance of a rate gain even in the face of high CPI numbers. Indeed, it’s increasingly likely the Fed will cut, though the Fed Rate is already so low there isn’t much ammunition left there to use.
We’ve seen and made comparisons to the 1970s, but on the credit side things look increasingly like the 1980s Latin American debt crisis. That crisis made virtually every major bank in the US technically insolvent for several years. In the end, people just looked the other way while a steep yield curve eventually allowed most banks to earn their way out of trouble while the most incompetent banks were allowed to fail. Japan went though a similar experience in the 1990s, though it took longer and was more painful because no one owned up to the problem for years. Japanese banks, not ironically, have had little exposure to this housing bubble.
There is going to be a lot of anger over bank rescues and recapitalizations. Many will think, rightly, that the idiots who created the mess are getting off too easily. Nonetheless, the real danger we see is deflation if lending doesn’t pull out of its dive soon. The move last week to curtail shorting of bank shares is just one of many moves we’re likely to see to try and change sentiment. Going forward, there may yet be rule changes to make it tougher to ‘speculate’ on things like oil prices. We hope this doesn’t come to pass since we’re pretty sure most spec money is on the short side of the oil market right now.
For all the credit problems right now there is still a lot of money in the world, though a good chunk of if is outside the US. We expect continued heavy spending on infrastructure in many regions, and that they could be joined by the US itself post election. The US needs that spending anyway and infrastructure has been proven to be some of the most effective “make work” money. One of the secrets to China’s success has been its willingness, and lack of impediments, to huge funding of money on roads, power, and communications. The same thing is now happening in Russia, which has horrible infrastructure but gushers of money thanks to oil. India needs it desperately too if it is ever to pace China on economic growth.
Infrastructure spending means “stuff” should to continue to be a winning sector, though maybe not next week or next month in terms of share prices. The markets’ perception is so negative now that winners are simply being sold, but even if your portfolio seems to be telling you otherwise the materials sector is one of the few that actually has had pricing power lately.
Commodity prices will continue to be historically strong, but it simply will take a better market environment for anyone to care, and to take notice that things like zinc and nickel are selling below marginal production cost. There may be more bargains before the retrenchment in equities is over, but bargain hunters will be rewarded if they chose companies with growing resources and the ability to weather the storm.
If shrinking credit markets continue to be the focus, the Fed will continue to be accommodative even while true-market interest rates (the spread) stay relatively high. Back stopping stupid investment banks and trying to rescue homeowners will mean more debt expansion for the US government. That combined with loose monetary policy will keep the US Dollar relatively weak. That will be a boon for gold and silver, which have held up well in even in the face of plunging oil prices. Gold appears to have again decoupled from oil, and may even decouple from the Dollar again as long as traders feel the need for a place to hide.
Whatever one thinks about peak oil and the power of speculators there is no doubt that oil prices falling farther is the best possible scenario for the economy at large. It would provide the quickest improvement to discretionary consumer spending, not to mention peace of mind.
The next few months will be rocky. Let’s hope the monetarists win the argument - and that this time the liquidity tap is eased down before the next bubble forms.
David Coffin and Eric Coffin
From the June 2008 HRA Dispatch
David Coffin and Eric Coffin are the editors of the HRA Journal, HRA Dispatch and HRA Special Delivery publications focused on metals exploration, development and production stocks. They were among the first to draw attention to the current commodities super cycle and have generated one of the best track records in the business thanks to decades of experience and contacts throughout the industry that help them get the story to their readers first. Please visit their website at www.hardrockanalyst.com for more information.
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