When Inflations Clash

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It is important
that you do not take too seriously the financial media’s explanations
for rising or falling stock markets. If the explanation is "inflation,"
pay little attention.

When you read
about "inflation," be aware of the fact that this means
"the most recent data on price inflation." These figures
are far less relevant than the most recent data on monetary inflation.
This is why I keep reminding readers with money on the line to monitor
the monetary
charts published by the Federal Reserve Bank of St. Louis
.

Last week,
Asian stock markets tumbled by close to 15%. You can see the
charts of several Asian nations here
.

Click on any
country’s name on the left column.

Asian bond
markets also fell.

The Dow Jones
Industrial Average got close to its 2000 peak two weeks ago; then
it fell. Gold and silver have also fallen. What is going on?

We are seeing
the clash of two inflations: price inflation and monetary inflation.

TWO DEFINITIONS
OF INFLATION

Monetary inflation
is the basis of price inflation, except in rare occurrences, such
as a war or an earthquake, where unexpected falling supplies are
the cause: "The same number of currency units chasing too few
goods."

In the United
States and around the world, monetary inflation is the norm. But,
very occasionally, central bankers decide almost simultaneously
to put on the brakes. They stabilize money. Then we see the clash
of the two inflations.

The St. Louis
Federal Reserve Bank publishes a
chart of the four major currencies
: U.S. dollar, Canadian dollar,
Japanese yen, and British pound. This chart tracks the reserve money
data, which reveal central bank monetary policy. It’s worth printing
out.

You can see
that there was parallel policy in 1999: inflationary.
The Canadian central bank was creating reserves at an astronomical
rate: 25% per annum. The other countries were creating reserves
in the 10% to 15% rate — high.

Then, without
warning, the central bankers reversed their policies in 2000. Canadian
reserves fell like a stone at minus 7%. The Bank of Japan’s rate
of reserve creation fell to 0%. So did the Federal Reserve System’s.
That coincided with the collapse of the Nasdaq and the general U.S.
stock market.

Then, in 2001,
all four banks reversed policy again: back
to monetary inflation. The Bank of Japan expanded reserves at a
28% rate, or close to it.

Ever since
2005, all but the Bank of England have been reducing the rate of
monetary inflation: under 4%.

Ever since
the final week of January, 2005, the Federal Reserve has almost
stabilized the adjusted monetary base.

This is monetary
disinflation. When monetary disinflation hits price inflation head-on,
there is a crash in the equities markets. The stock market boom,
fueled by rising monetary reserves, threatens to become a bust.

Ludwig von
Mises described this boom-bust phenomenon as early as 1912 in his
book, The
Theory of Money and Credit
. I have written a
short book on Mises’ monetary theory
, for those of you — in
addition to my mother — who are interested.

THE BANK
OF JAPAN OPTS OUT

To the question,
"What happened to Asia’s stock markets?" — there is an
answer. It may not be the best answer, but it makes sense to me.
The Bank of Japan is in the process of abandoning its policy of
zero interest rates.

This policy
has subsidized Japan’s ailing commercial banking system, which is
still sitting on a pile of bad loans left over from the 1990s. It
has kept equity prices higher than would otherwise have been the
case. The same goes for property prices. Yet both markets fell substantially
in the 1990s.

The legend
of Japanese deflation is inaccurate. Japan’s retail prices had slightly
down years and slightly up years through the 1990s. See
the chart, "Inflation."

As you can
see, price deflation was low whenever it existed, which was infrequently.
From 1990 until 1995, the consumer price index was positive except
briefly in 1995. It moved up in 1997 to about 2%. Then it moved
down in the aftermath of the Asian currency crisis of 1998. In this
decade, price deflation never got more than about 1% per year.

This should
warn you: Do not take seriously the headlines of roaring price inflation
as the cause of the recent fall in the U.S. stock market, any more
than you should take seriously stories of roaring price deflation
in Japan.

Ambrose Evans-Pritchard’s
article in the May 29 issue of The Telegraph reported on
a shift in policy by the Bank of Japan.

Governor
Toshihiko Fukui has bled more than $140bn from his banking system
since March 9 to reduce a menacing overhang of liquidity left
from the battle against deflation. He is halfway through.

No longer
buying fistfuls of US Treasuries with printed money to hold down
the yen, the Bank of Japan has been the silent force pushing up
global bond yields this year by 0.8pc — the jump that really lies
behind the market rout.

It is possible
for the bond market and the stock market to rise or fall together.
They rose together in the United States from 1982 until 2000. They
are now falling together in Asia.

Japan’s central
bank is now selling dollars.

Japanese
holdings of US Treasuries have fallen by $74.5bn since December.
"We are reaching an inflection point in monetary policy,"
said Mr. Fukui.

In other words,
the subsidy provided to the U.S. government’s debt market by the
Bank of Japan has ceased for the time being. Yet this has been the
most important subsidy for this market for the last decade.

This has ominous
implications for the yen carry trade. For almost 15 years, the Bank
of Japan has subsidized large-scale speculators, who borrowed yen
at almost 0%, bought foreign currencies, and then bought debt obligations,
especially bonds. This was easy money on a massive scale. When you
can get free money, you are tempted to do it again and again. But
then comes the day of reckoning. As Evans-Pritchard puts it,

Hedge funds
that had borrowed for zilch in Tokyo, to lend for a fat premium
to overheating Iceland and New Zealand, began rushing for narrow
exits.

The storm
has since swept up much of the globe, setting off the steepest
falls in emerging market stocks and bonds since the Russian default
in 1998.

"Most
people underestimated the effects of monetary tightening in Japan,"
said Phillip Poole, an economist at HSBC. "The liquidity
that has driven these markets is being withdrawn."

This policy
of Japan has an acronym: ZIRP (zero interest rate policy). This
policy is now coming to an end.

Few investors
lose sleep worrying about life after zirp, but our guardians at
the Bank of International Settlements view it as the greatest
imminent risk to global markets.

Adding to the
threat of worldwide recession, the European central bank is also
tightening money. The European housing bubble has created concern
over rising price inflation, which is driven by rising real estate
prices.

Judging by
the apocalyptic tone of the Bundesbank’s May report, Europe is
on the brink of a monetary shock going far beyond the mincing
half-measures trickled out until now by Jean-Claude Trichet, ECB
chief and French "soft euro" inflationist.

Evans-Pritchard
refers to the German central bank (Bundesbank) as Buba. It reminds
me of that mythical American redneck, Bubba.

Germany is
back, and a reawakened Buba is snorting with the same bloody-minded
determination it displayed before causing the 1987 crash and the
1992 bust up of the ERM [European Exchange Rate Mechanism].

This threat
of rising rates threatens the U.S. dollar. If Japan allows rising
short-term interest rates, and Europe allows rising short-term interest
rates, the dollar will come under selling pressure. To keep the
value of the dollar high, the Federal Reserve will have to retain
its present flat-reserves policy, thereby letting short-term interest
rates rise.

This is bad
news for the ARM [adjustable rate mortgage] market and the housing
market generally. Evans-Pritchard’s analysis is spot-on.

Ben Bernanke
was back-peddling fast in a letter to Congress last week, pleading
that core CPI inflation "overstates" price rises. "Monetary
policy must be forward-looking," he said.

Has the Fed
already gone too far, baking a recession into the pie? Will the
delayed effects of past tightening kick in, with mounting ferocity,
just as the housing boom plummets into bust?

"Housing
mayhem seems unavoidable. The US hard landing begins now,"
said Charles Dumas, global strategist at Lombard Street Research.

Mortgage
applications are down 17pc in a year. House sales are down 5.7pc,
and inventories of unsold new houses are at their highest since
1996. The central prop holding up the US consumer boom is crumbling,
leaving behind record household debts equal to 127pc of disposable
income.

[Note: This
article was removed or else the link died on Tuesday, May 30.]

Evans-Pritchard
is not alone in his analysis. William Pesek wrote a piece for Bloomberg,
published the same day, May 29, as Evans-Pritchard’s article.

In Mumbai
in January, I asked India’s No. 2 central bank official the same
question I pose to every policy maker these days: What does Japan’s
revival mean for Asia?

Without a
moment’s hesitation, Rakesh Mohan replied: "The yen-carry
trade will make things interesting." . . .

Over the
last decade, the trade — which exploits the gap between ultra-low
Japanese interest rates and higher ones elsewhere — has become
a staple in markets. In many cases, anyone borrowing for next
to nothing in yen and parking the funds in, say, higher-yielding
U.S. Treasuries or higher-returning Indian stocks found it to
be a sure bet.

That’s about
to change as Japan’s recovery leads to higher rates in the world’s
second-biggest economy.

I find it interesting
that the financial press has finally figured out what I
wrote about two years ago, in May, 2004
. The carry trade is
the Achilles heel of today’s boom.

Pesek writes:

Short-term
rates and bond yields in Japan have been negligible for so long
that investors take them for granted. Japanese recoveries tend
to fizzle faster than they emerge. The Bank of Japan hasn’t built
much credibility in markets, having failed for some 15 years to
stabilize growth and avoid deflation.

Yet Japan’s
long-awaited return to the economic plus column is here. And even
if the country doesn’t grow 5 percent a year, there can be little
doubt that the BOJ will raise rates from zero percent. The central
bank is keen to return some normalcy to Japan’s monetary policy.

Global markets
have been slow to grasp the specter of higher Japanese rates.
In recent weeks, though, surprisingly large moves in markets from
Iceland to Turkey to India have been partly attributed to the
unwinding of yen trades. And where yen-volatility is concerned,
we probably haven’t seen anything yet.

The worldwide
housing boom has rested on the Bank of Japan’s monetary expansion
and the parallel expansion by the other major central banks. Now
this is ending: in Japan, in Europe, and in the United States.

Today’s financial
press wailing about U.S. price inflation will be replaced by wailing
about a worldwide recession. What happened to Gerald Ford’s 1975
WIN program (Whip Inflation Now) should remind us: Recession can
follow the next year. That reversal cost Ford the Presidency.

Pesek
worries in print
that no one knows how big the yen carry trade
is.

What makes
the yen-carry trade so worrisome — and easy to dismiss as a potential
problem for markets — is that no one really knows how big it is.
It’s not like the BOJ has credible intelligence on how many companies,
hedge funds or mutual funds borrowed in yen — or how much — and
put the money into assets elsewhere.

It would
be more comforting if the Bank for International Settlements,
the International Monetary Fund or the Federal Reserve Bank of
New York had a better handle on all this. Who really knows how
many purchases of Shanghai properties, Google Inc. shares, Zambian
treasury bills, bars of gold or derivatives are related to yen
borrowings?

The American
investing public has not yet got the message. Few investors have
heard of the carry trade. Few fund managers are prepared for its
potential negative consequences. The central banks are now reversing
a decade-old policy.

I don’t think
they will maintain this disinflationary policy, once it becomes
clear that the carry trade is unraveling and taking the equity markets
and the real estate markets with it. But whenever the major central
banks pursue the same policy, there is going to be simultaneous
trouble.

CONCLUSION

Cash is not
trash. Foreign currencies are not trash.

But it’s safest
to hold them in the form of short-term CDs. Bonds are possible as
ways for speculative profits. But rising long-term rates are likely
because of the unwinding of the yen carry trade. When speculators
sell non-Japanese currencies to repatriate yen in order to buy yen
and unwind their positions, they will sell non-yen bonds first.
That will put upward pressure on long-term interest rates.

I
see a continuation of bad news for all stock markets. I also see
trouble ahead for the U.S. dollar.

I also see
what the slogan will be for the Democrats in 2008: "It’s the
economy, stupid . . . again!"

June
2, 2006

Gary
North [send him mail] is the
author of Mises
on Money
. Visit http://www.garynorth.com.
He is also the author of a free 17-volume series, An
Economic Commentary on the Bible
.

Gary
North Archives

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