Price Inflation Has Never Disappeared by Gary North

Actually, Weiss never predicted falling inflation in the 1980’s or any other time. He has spent his entire career predicting outright price deflation. In every year that he made this prediction, he was wrong. So was his father. It is good to see that reality has at last caught up with his forecast. I hope this continues.

The inflation vs. deflation debate heated up in 1974, when gold bug newsletter writer C. V. Myers began predicting deflation. In every year since 1974, the U.S. consumer price index has risen. This has taken place even in the face of what Dr. Kurt Richebächer calls "hedonic price indexing" by the government’s statisticians: attributing increased efficiency by computers as a major factor in putting deflationary pressure on the overall economy. There has been a deflationist faction inside the hard-money newsletter camp ever since.

The price index that I monitor most closely is the Median CPI, which is published by the Cleveland Federal Reserve Bank. It has begun moving up, after a year of stability in the 2.4% range. In October, it moved up by 0.3% over September. September had moved up by a mere 0.1% over August.

When you look back over the preceding two decades, month by month, you discover that the annual rate of increase has been in the 3% range or higher. Only in 2003 did it fall into the 2% range.

We have been living for a year in a uniquely low price inflation period, but October indicates that the economy may be heading back toward 3% per annum or higher.

WHAT THE FEDERAL RESERVE SYSTEM IS DOING

The one thing that the FED can control directly is the adjusted monetary base. That statistic indicates rising monetary inflation until last August, then an actual contraction. The increase, year to year, is about 6%.

The statistic known as money of zero maturity, which I favor slightly over the other monetary aggregates, indicates the same pattern: up by 6.6% over the full year, but falling since August.

Finally, there is the more traditional M-2. Same pattern: up by over 5% year to year, but falling since August.

Short-term interest rates have remained in the 1% range – very low. Yet the FED is not increasing the money supply. The economy, we are being told, is growing. This would indicate that businesses should be ready to borrow in order to expand operations. But if the money supply is actually falling, and if increased demand places upward pressure on interest rates, then why hasn’t the federal funds rate for overnight money increased?

This tells me that there is a problem with the assumption of increasing demand for loans. My suspicion receives some support from the figures for bank loans. Bank credit rose to 12% above the previous year’s level in the first half of 2003, but then fell back to around 7%. Total loans and leases in bank credit at commercial banks rose in mid-year to 10% above the previous year, but then fell back to about 6%.

Then we come to commercial and industrial loans at commercial banks. This statistic went negative in mid-2001, and it has yet to recover. It fell throughout the first half of 2002 to a negative 8% or thereabouts, then "recovered" to negative 5%, briefly, in mid-2003. Since then, it has fallen back to negative 7%.

The conclusion I have reached – always subject to revision in response to better evidence – is that the economic recovery has been based on traditional anti-solvency stimuli by the government. First, there was the two-year increase in the money supply through August, 2003. Second, the economy has recovered slowly in response to classic Keynesian/supply-side stimuli: a large increase in military spending coupled with a mild tax cut. In the face of a slowly receding recession, these fiscal stimuli have produced a federal deficit approaching $500 billion.

The commercial and industrial business community has been unwilling to commit to major increases in debt in order to finance newly capitalized projects. Businessmen have been cautious in further indebting their companies. There was some optimism through the first half of the year, but this optimism is fading.

The FED for some reason began putting on the monetary brakes in August. There has been no formal announcement from the Board of Governors regarding a change in monetary policy, but it appears as though there has been a change.

At this point, I have only this suggestion for the change: the Board of Governors saw that the Federal Open Market Committee could ease back on the digital printing press in August without causing a rise in short-term rates. The FED actually started selling its T-bills. This policy, if continued, will produce a recession, but in the meantime, it defers the rapid escalation of price inflation in 2004, which would otherwise have put upward pressure on long-term interest rates and therefore downward pressure on the market value of mortgages, T-bonds, and corporate bonds.

WAL-MART’S LAMENT

You may have missed this excellent piece of analysis on the Daily Reckoning’s Web site. I reprint it here for two reasons: (1) you won’t read about this elsewhere; (2) it points to a set-back for the consumer-driven economy in 2004. Dan Ferris is the author.

Wal-Mart knows the paycheck-to-paycheck consumer is its lifeblood. It also knows that most paychecks are issued on the 15^th and the 30^th of each month. Government-issued checks come out at the end of the month. If you want to know how the wage earners are doing, you have keep track of the middle of the month.

So, each month, Wal-Mart adds up all the sales from all of its stores on the 14^th of the month, when consumers are out of money. Then Wal-Mart subtracts that figure from all the sales from all of its stores on the 15^th of the month, the day Joe and Mary Paycheck get paid. The resulting difference is perhaps the single best measure of the liquidity of Middle America.

"The consumer’s liquidity crisis is the worst that Wal-Mart has seen and is the most pronounced in the last five to seven years," according to a recently issued Deutsche Bank report, quoted in Grant’s Interest Rate Observer.

Lower interest rates have been great for homebuilders, mortgage lenders and car dealers. But Wal-Mart doesn’t sell homes or cars. In fact, money once spent at Wal-Mart now goes into the new house and/or the new car. The company cites the rising cost of gasoline as a drag on earnings. . . .

Fitch Ratings agency tracks chargeoff activity in its Fitch Ratings Credit Card Chargeoff Index. This index is updated regularly in its Credit Card Movers & Shakers newsletter. The latest edition is dated Oct. 28, 2003. It reports that, for the month of August 2003, the chargeoff index is up 104 basis points (1.04%) over last year. Fitch concludes, "As consumers remain financially burdened due to the economic landscape, performance is expected to remain challenged over the near term and worsen later in fourth-quarter 2003."

The American consumer has the next 30 days to spend himself into a mini-crisis in January. Christmas is the season of seasons for retailers. Most Americans cannot resist splurging at Christmas time, no matter what the consequences are in January. If an American has any money in the kitty, or if there is any remaining line of credit in his credit card, the Christmas season is the most likely time of the year for doing stupid things.

I am not forecasting some kind of looming collapse. I am predicting a very different kind of election year. Unless the FED is lying low, ready to prime the pump with new money in the first half of next year – which is possible – 2004 is not going to be a boom year. Unless the FED reverses course and starts creating new money, the consumer-driven economic recovery is going to go flat before next November. It may even go back into recession, although with short-term money so cheap, this does not seem likely. But the good economic news of the second half of 2002 is unlikely to be matched next year.

THE FED’S CASE FOR VAGUE OPTIMISM

In a recent speech, FED Board member Roger Ferguson gave his first public address in a year. He stated the obvious (which is typical of FED speeches). These speeches vary from vaguely optimistic to vaguely cautious. Ferguson is vaguely optimistic.

The household sector has been the driving force in this expansion. For example, in the third quarter, real personal consumption expenditures increased at an annual rate of 6½ percent, while real residential investment surged 20 percent. Last quarter’s strength in consumer spending was fueled by the midyear tax cuts, the waning influence of negative wealth effects from the past slide in equity prices, and some improvement in consumer sentiment from the war-related lows registered in March. In addition, very generous incentives on autos and light trucks boosted light vehicle sales to annual rate of 17½ million units in the third quarter. After such substantial increases last quarter, it has not been surprising that consumer spending has softened as we moved into the fourth quarter. Still, the fundamental determinants of consumer spending remain favorable, and consumer sentiment is increasingly upbeat.

If consumer sentiment is likely to remain upbeat, why is the typical Wal-Mart consumer stretched so thin? Sentiment will not remain upbeat when the typical consumer runs out of money before the next paycheck. Ferguson continued. The problem is the business sector.

As I noted before, the business sector has been the locus of weakness in this expansion. However, the extreme caution that had been gripping firms now appears to be dissipating. Real outlays for equipment and software rose at an annual rate of 15½ percent in the third quarter, after an increase of 8¼ percent in the second quarter.

Businesses that invest in computer technology are investing in capital assets that depreciate fast: probably by one-third to one-half per annum. This burns up capital fast.

What Ferguson admitted as an outside possibility, I regard as highly likely in 2004.

The sustainability of the recovery will depend importantly on future trends in employment, household spending, and business investment. Twice before in this recovery we have seen short periods of strong growth, followed by a return to sluggish, subpar growth. Given the strength of the incoming data that I have just outlined, the risk that the economy will again stall out must be given a smaller probability than that assigned just a few months ago, but the risk cannot be discounted completely. For example, the strength in consumer spending in the third quarter might prove to be temporary – a one-time surge related to the fiscal stimulus. Indeed, analysts who subscribe to this view would take some solace in the latest data on non-auto retail sales. Under these circumstances, businesses likely would remain very cautious about the demand conditions they expect to prevail in the year ahead. This would make them reluctant to expand and hire new workers – factors that would hold down economic expansion in 2004. While the consensus forecast for next year calls for a growth rate of 4 percent (on a fourth-quarter-to-fourth-quarter basis), which seems reasonable, a weaker outcome than that is not hard to imagine.

I, for one, imagine it. The experts at the FED are not wildly optimistic. They understand that business investment is the key to a sustained recovery. Consumer spending is too fickle, too dependent on a one-time tax cut. Business spending has barely appeared in an economic recovery that technically began two years ago.

CONCLUSION

The stock market is unable to break into the 10,000 Dow Jones range. Gold is unable to break out of the 390’s. Both resistance points seem to indicate the existence of a barrier in consumer spending. The consumer is unable to bring the stock market’s underlying strength back to what it was in early 2000. The gold market points to price inflation, a falling dollar, and rising demand for gold. But the FED’s recent policy of monetary contraction threatens both upward moves.

Are we facing price deflation? Hardly. Are we facing the FED’s willingness to reduce the rate of economic recovery in an attempt to keep price inflation from escalating, thereby threatening the market for government bonds? I think so. So, it has shrunk the money supply. It will do what it can to delay the collision between monetary inflation and price inflation. Right now, it’s betting that price inflation is a greater short-term threat than deflation is.

So am I.