Is the Inflation Camp on the Bubble?

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For the past
several years there has been an ongoing debate among bears about
how numerous U.S. imbalances would be resolved: debts, deficits,
under-saving, over-consumption, and asset bubbles. The deflationists
argue that bubbles always burst and when they do, debtors default.
Inflationists make the case that in a social democracy the government
will do everything in its power to bail out the debtor class, even
run the printing presses. Cynics point out the obvious: a central
bank will always try to mitigate the pain of its banking constituents.
Their contentions all have merit.

Four years
ago deflation fears were rampant. The tech bubble was bursting,
the economy slipping into recession, and the Fed seemed impotent
to stem the slide. The Fed responded with a massive dose of ultra-cheap
credit which at first had little effect, but eventually made its
way into the next asset bubble: real estate. Today inflation — particularly
"asset inflation" — is the toast of the town; speculators
are bingeing on stocks, real estate, and commodities; professionals
are reaching for yield with exotic debt instruments; and the Fed
chairmanship has returned to rock star status. Meanwhile, expectations
for consumer price inflation remain guarded; U.S. economists predict
a 2.4% rise in the CPI this year and inflation-indexed bond investors
expect the CPI to average 2.5% over the next 10 years. In the February
2006 issue of The Gloom, Boom & Doom Report, Hong Kong-based
investment adviser Marc Faber discussed this atypical state of affairs:

I regard
the current investment scene as most unusual, in the sense that
everybody is very positive about one or another asset class. Equity
fund managers around the world are positive about equities in
both the developed economies and in emerging markets, while commodity
traders are positive about commodities, gold bugs about precious
metals, property developers about real estate prices, art aficionados
about art prices and collectibles, and bond investors about bond
yields declining further. This universal bullishness about all
asset classes is uncommon… So, as a sceptic and contrarian investor,
I am deeply concerned about this "continuous asset inflation"
consensus amidst a benign "consumer price inflation"
scenario.

The inflationary
side of the boat has clearly gotten crowded. What will cause it
to capsize? Dr. Faber offers two possible scenarios: a crash in
asset prices or an accelerating consumer price inflation in which
asset prices decline in real terms, though not necessarily
in absolute terms.

Before exploring
each of these scenarios, let's take a closer look at the inflationary
process.

What is "inflation?"
Before World War II, the term was defined as an artificial increase
in the supply of money and credit (brought about by a central bank
in cahoots with the banking system). Since then, inflation has been
spun to mean a general increase in prices. As Ludwig von Mises pointed
out, there is a reason for this:

To avoid
being blamed for the nefarious consequences of inflation, the
government and its henchmen resort to a semantic trick. They try
to change the meaning of the terms. They call “inflation” the
inevitable consequence of inflation, namely, the rise in prices.
They are anxious to relegate into oblivion the fact that this
rise is produced by an increase in the amount of money and money
substitutes. They never mention this increase. They put the responsibility
for the rising cost of living on business. This is a classical
case of the thief crying “catch the thief.” The government, which
produced the inflation by multiplying the supply of money, incriminates
the manufacturers and merchants and glories in the role of being
a champion of low prices.

Inflation is
the disease and rising prices are a symptom. Sometimes
the symptom goes undetected due to productivity gains from new technologies,
the dumping of commodities by a splintering empire, or the entry
of billions of capitalists into the global economy. Sometimes the
only rising prices are in assets, which no one ever seems to complain
about. Or if prices do start to rise at the checkout counter or
at the gas pump, economists can simply strip them out, leaving a
less volatile index of "core" prices.

Of course inflation
is an insidious tax, transferring wealth from one group to another,
but the damage to the economy adds insult to injury, as Frank Shostak,
chief economist with Foresight Research Solutions, explains:

We have seen
that increases in the money supply set in motion an exchange of
nothing for something. They divert real funding away from wealth
generators toward the holders of the newly created money. This
is what sets in motion the misallocation of resources, not price
increases as such, which is only the manifestation of this misallocation.

Moreover,
the beneficiaries of the newly created money, i.e., money out
of “thin air”u2014are always the first recipients of money, and so
they can divert a greater portion of wealth to themselves. Obviously,
those who either don't receive any of the newly created money
or get it last will find that what is left for them is a diminished
portion of the pool of real funding.

Additionally,
real incomes fall not because of general rises in prices, but
because of increases in the money supply, which gives rise to
nonproductive consumption. In other words, inflation depletes
the real pool of funding, which undermines the production of real
wealthu2014i.e., a lowering of real incomes. 

How exactly
does our government create inflation? The Federal Reserve does not
literally "drop money out of helicopters" or "run
the printing presses," though these counterfeiting metaphors
are apt. Instead, the Fed engages in a clever two step process:
1) it purchases, or "monetizes," assets with money created
"out of thin air" and 2) it allows the banking system
to pyramid credit on top of this new money. In The Case Against
the Fed (1994), Murray Rothbard explained how this process works:

Suppose that
the "money multiplier" — the multiple that commercial
banks can pyramid on top of reserves, is 10:1. That multiple is
the inverse of the Fed's legally imposed minimum reserve requirement
on different types of banks, a minimum which now approximates
10%. Almost always, if banks can expand 10:1 on top of
their reserves, they will do so, since that is how they make their
money. The counterfeiter, after all, will strongly tend to counterfeit
as much as he can legally get away with. Suppose that the Fed
decides it wishes to expand the nation's total money supply by
$10 billion. If the multiplier is 10, then the Fed will choose
to purchase $1 billion of assets, generally U.S. government securities,
on the open market.

In the first
step, the Fed directs its Open Market Agent in New York City to
purchase $1 billion of U.S. government bonds. To purchase those
securities, the Fed writes out a check for $1 billion on itself,
the Federal Reserve Bank of New York. It then transfers that check
to a government bond dealer, say Goldman, Sachs, in exchange for
$1 billion of U.S. government bonds. Goldman, Sachs goes to its
commercial bank — say Chase Manhattan [editor's note: now a part
of JP Morgan Chase] — deposits the check on the Fed, and in exchange
increases its demand deposits at the Chase by $1 billion.

Where did
the Fed get the money to pay for the bonds? It created the money
out of thin air, by simply writing out a check on itself. Neat
trick if you can get away with it!

Chase Manhattan,
delighted to get a check on the Fed, rushes down to the Fed's
New York branch and deposits it in its account, increasing its
reserves by $1 billion.

But this
is only the first, immediate step. Because we live under a system
of fractional-reserve banking, other consequences quickly ensue.
There are now $1 billion more in reserves in the banking system,
and as a result, the banking system expands its money and credit,
the expansion beginning with Chase and quickly spreading out to
other banks in the financial system. In a brief period of time,
about a couple of weeks, the entire system will have expanded
credit and money supply another $9 billion, up to an increased
money stock of $10 billion.

As Rothbard
pointed out, the Fed is the conductor while the banks play the music.
Over the past five years we can see how they acted in concert to
create the latest inflationary cacophony. Fed holdings of U.S. government
securities increased by $229 billion while money supply (M3) grew
by $2,996 billion, or 42%. Clearly, credit expansion is not only
critical to the inflation process, it does the heavy lifting. (Note:
The expansion of credit does not just take place through the banking
system. The U.S. boasts the most advanced credit distribution system
in the world, aided by government-sponsored mortgage lenders, the
derivatives market, the repo market, and Wall Street's ability to
package and "securitize" loans. Foreign central banks
also assist in providing credit.)

This brings
us back to our original inflation-deflation debate. After throwing
the inflation switch on full throttle, the Fed has backed off somewhat
with 14 "measured" rate increases over the past 20 months.
Why? Perhaps they no longer believe their own sales literature.
As the table below shows, the official inflation measures are grossly
understated. Over the last five years, prices for practically everything
have exceeded the CPI, driven by rapid growth in money and credit.
(The lone exceptions: grains and large-cap equities, which were
held back by the deflating 2000 technology balloon.) Notice that
the inflation aggregates still experienced strong growth in 2005
despite higher rates.

Inflation
in the United States, 2000–2005 (all figures annualized)

Category

Source/
Index

Last
5 Years
(2000–2005)

Last
Year
(2005)

Housing

OFHEO
Index

+9.1%

+11.6%

Large-cap
Equities

S&P
500 Index

-1.1%

+3.0%

Small-cap
Equities

Russell
2000 Index

+6.8%

+3.3%

Credit-related
Equities

Bearing
Credit
Bubble Index

+8.0%

-4.5%

Commodities

CRB
Index

+7.8%

+16.9%

Oil

West
Texas Intermediate

+15.6%

+30.2%

Grains

Dow
Jones-AIG
Grains Index

-6.4%

-4.7%

Gold

London
PM Fix

+13.5%

+17.8%

Luxuries

Forbes
Cost of Living Extremely Well Index

+4.6%

+4.0%

Fed
Holdings of
U.S. Gov't Securities

Federal
Reserve

+7.6%

+3.7%

Money
Supply

M3

+7.2%

+7.3%

Mortgage
Credit

Flow
of Funds

+11.7%

+12.9%

Official
Inflation

Consumer
Price Index

+2.4%

+2.9%

Are investors
overestimating the Fed's ability and will to inflate? For at least
the short- to intermediate-term, we believe that to be the case.
The Fed appears to be in a box. They have allowed the inflation
genie out of the bottle, leaving asset bubbles, a declining dollar,
and rising consumer prices in their wake. An aggressive easing
— at least at this point — would surely exacerbate the situation,
and appears highly unlikely. Further, newly anointed Fed chairman
Ben Bernanke must establish his "inflation fighting" credentials
and paint a picture of continuity with the previous regime.

Meanwhile,
the air is slowly leaving the housing bubble. Its deflation appears
to have plenty of room, perhaps for the next six months, to gain
momentum. By the time the Fed reacts to declining home prices and
rising defaults, it will be too late. Once a bubble starts to burst,
there is no stopping it, as the Bank of Japan proved from 1991–1995
with the Nikkei bubble and the Fed proved from 2001–2003 with the
Nasdaq bubble. In a post-bubble environment, the credit creation
machine becomes crippled, as lenders, borrowers, and speculators
go into post-traumatic shock.

At some point
we would expect the debtor class to beg for inflation, and for the
Fed to give it to them. The Fed will probably be forced to rely
less on banks and other intermediaries and more on monetization
— purchasing various assets and paying for them with money created
out of thin air. Some have suggested that the Fed will branch out
from buying U.S. government securities, purchasing stocks, corporate
bonds, mortgage-backed securities, and even houses, if necessary.
This is certainly among Bernanke's contingency plans (as some of
his academic papers indicate), though it would be a radical departure
from Fed procedure. It will certainly not happen anytime soon and
will come far too late in preventing the housing and consumption
balloon from popping.

Some in the
inflation camp are convinced we are on the road to hyperinflation.
While we don't necessarily disagree, the path may take more twists
and turns than they expect. Mr. Market tends to follow the course
that inflicts the maximum amount of pain. A relative decline in
asset values would bail out the speculator, whereas an absolute
decline would take him and his creditor out to the woodshed. The
investing crowd would then likely react to the new deflationary
reality by selling off assets, paying down debt, and actually saving…
just in time to get smashed by a new wave of inflation.

Under
either scenario — a real or absolute decline in asset values — gold
will almost certainly outperform real estate and the shares of mortgage
lenders.

March
4, 2006

Kevin
Duffy [send him mail]
is a principal of Bearing Asset Management.

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