by Gary North
A year ago (August 2), I sent out a report, "Inflation and Inflation Indexes." I have posted it here (this week only).
Back then, there was monetary inflation but fairly low price inflation. Today, there is actually monetary deflation but twice the rate of price inflation that prevailed a year ago.
What is going on?
More important, is this likely to go on?
In my 2005 report, I made this point, which bears repeating: Inflation is a monetary phenomenon. When a central bank adds to its holdings of assets, it does so by creating new money and purchasing the assets with the newly created money. This money is spent into circulation in order to buy the assets, and then spent by the recipients of this money. The new money multiplies through the fractional reserve commercial banking system.
The vast majority of money users know nothing of central banks, fractional reserve banking, and the arcane formulas used by statisticians to define money — competing definitions. What the average money user knows is that the items he normally buys are either rising in price, staying the same, or falling. In fact, consumers have only a vague sense of this. What catches their attention is what a particular asset costs, especially one that is getting media attention. It's like global warming. The public's sense of increased heat is fanned by the media's coverage of the story. Worldwide, thermometers may not actually be rising, which has in fact been the case since 1998.
The creation of an official index number for prices is a complex task. The statisticians choose representative — they tell us — commodities and services to monitor in their index. Then they "weigh" each commodity or service as to its overall importance in a representative — they assure us — person's budget. Then they take random samples of representative — they cross their hearts and hope to die — transactions, but always retail transactions. Then they use a highly complex formula to compute the index. Then they adjust it for seasonal variations.
Finally, if it still looks as though prices are rising, which will push up the federal government's cost-of-living adjustments (COLAs), especially for Social Security, they deflate it by applying a "hedonic pricing" deflator. This adjusts prices downward according to hypothetical increases in quality, which are of course incapable of being quantified even when not hypothetical. In short, the statisticians make up a deflationary number for each product that is plausibly improving in quantity.
Then they produce several related index numbers that have certain prices removed, such as energy or food, which are said to be volatile and therefore not indicative of the trend.
You pay your tax money — depreciating — and you get your choice.
THE INDEX I MONITOR
For a number of reasons, I follow the Median Consumer Price Index, which is published monthly by the Federal Reserve Bank of Cleveland.
It's not that I take the figure seriously as an indicator of prices that affect me personally. What interests me is the trend of the index. While I have little confidence in any of these official indexes, I do have confidence that the statisticians who compile them are committed to them as "the best that anyone can produce." As bureaucrats, they resist any tampering of the formulas. So, I can see the trend of a particular index.
In July, 2005, the Median CPI was rising at about 2% per annum. As of June, 2006, it had risen by 3.3% over the last 12 months. Its monthly increase was .4%, which puts it in the 4.6% per annum range if this rate continues.
This is a significant increase in the annual rate of price inflation when compared with what prevailed a year ago.
At the same time, the rate of monetary growth has not only fallen, it has gone negative. I follow the adjusted monetary base. From June 7 to August 2, it dropped at an annual rate of 0.5%. In recent weeks, both MZM (money of zero maturity) and M-2 have turned downward. You can monitor all of them here.
This brief period is not crucial. There are ups and downs constantly in these charts. The annual rate of increase of MZM and M-2 is in the 5% range. The annual rate of increase for the adjusted monetary base is 3.5%. So, with respect to Federal Reserve policy, there has been relatively low inflation, and it is falling. This is significant.
There is constant speculation — verbal and financial — about the next announcement of the Federal Reserve's Open Market Committee (FOMC). If you noticed, the media kept reporting on forecasters who said that there woild be a pause in the upward move. Then, every eight weeks, the FED increased the federal funds rate by .25%. The FOMC paid no attention to the forecasters. Neither did I.
When, on August 8, the FOMC left the rate alone, the Board said it was because price inflation is becoming less of a problem. There is a reason for this: the FED's monetary policies in 2006, which have tightened money.
The forecasters ought to look more carefully at the adjusted monetary base. This statistic provides the best recent evidence regarding FOMC policy. What it is telling us today is that the FED under Bernanke is slowing the increase of monetary reserves, which slows the increase of the monetary base. This is disinflationary.
In a time of rising price inflation, which we are in, a disinflationary monetary policy is supportive of an officially announced policy of raising the federal funds rate, which is the rate at which banks lend to each other overnight — the shortest of rates. Here is why.
Rising prices indicate prior monetary expansion. This echo effect will eventually begin to reflect recent monetary policy, which is tighter today than a year ago. Those retail sellers who expect to be able to pass on rising costs to consumers will find that consumers balk. New money is less plentiful than expected.
When this happens, retailers find that they have expanded too much. They must now retrench. They scramble for short-term credit to carry them over during the retrenchment period. This increases the demand. Yet the supply of new money — a major source of short-term credit in today's capital markets — is slowing. This combination drives up short-term rates. So, the FED's policy has been consistent with the FOMC's announcement of rising rates. In any case, it is the free market, not the FOMC's announcement, that sets the FedFunds rate. Speculators believe the FOMC only to the extent that FOMC policy reinforces its officially announced interest rate.
It will not take much to push short-term rates above long-term rates. This is the famous inverted yield curve. Long-term rates have been falling in recent weeks. This indicates that investors are moving money into 30-year T-bonds as a way to lock in their interest rate return. This indicates that they are worried about the return on alternative investments. They may also be worried about falling short-term rates: an effect of a recession. Short-term rates fall when a recession hits because short-term capital is preserved this way.
On August 7, 30-day T-bills were paying 4.95% and 30-year T-bonds were paying 5%. We are close to inversion. You can monitor these daily figures here.
It is not that an inverted yield curve causes a recession. Rather, it reflects a change in investor sentiment that is consistent with recession. Investors lock in a higher rate of return by buying T-bonds. They know there is price inflation of almost 5%. This, coupled with income taxes, puts their expected return into negative territory. They are losing wealth. Why would they do this? Because they believe they will lose even more wealth by keeping their money in stocks or short-term T-bills. Why? Because they expect a recession.
RECESSIONS AND PRICE INFLATION
Recessions put pressure on sellers to reduce output, lower inventories, and fire workers. All of these survival tactics put downward pressure on prices. There is greater supply being offered for sale in order to reduce inventories. To attract buyers, retailers reduce prices.
This has a ripple effect through the capital goods markets. Reduced demand for final consumer output reduces demand for the tools of production that produce output. It also reduces demand for commodities.
This is why I expect the price indexes to peak in 2006. By the end of 2007, I expect the rate of increase to be lower.
I do not expect general price deflation. We have not seen this in half a century, and even then only for a year. The public will not believe that price deflation will hit the U.S. economy.
Investors will expect the FED to open up the money spigot, once it looks as though price deflation is a possibility. To allow prices to deflate would be to follow policies associated with the Great Depression.
Sophisticated investors by now know that Bernanke regards FED monetary policy in the 1930s as a great disaster. Bernanke wrote this in 2002 for Milton Friedman's 90th birthday.
For practical central bankers, among which I now count myself, Friedman and Schwartz's analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman's words, a "stable monetary background" — for example as reflected in low and stable inflation.
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You're right, we did it. We're very sorry. But thanks to you, we won't do it again.
YOU AND RECESSION
This is not just an investment issue. This is an employment issue and career issue.
The Federal Reserve System forced down short-term interest rates to the lowest level in American history if we factor in price inflation. Savers took a terrible beating. It was done in the name of saving the stock market and keeping the housing boom alive, which is a major source of perceived wealth for consumers and a major employer.
People have concluded that there will not be employment-threatening recessions any more. The last one that did force up unemployment was in 1990, which is a distant memory for most Americans: the Cold War era. Unemployment peaked in June, 1992 — an echo effect of the 1990 recession — at 7.8%.
For young workers, that era is not only forgotten, it was never experienced. For older workers, it was part of their youth. Most people are not afraid of unemployment.
For white, married workers, the unemployment rate is always significantly lower than for the general economy. Still, it is unsettling when the "Help Wanted" signs disappear. Raises are delayed. Promotions become scarce. A gloom settles into the corporate boardrooms. Personal dreams of personal wealth through stock options crash along with the stock market.
The FED does not want to get blamed for this. It will do whatever he can to reverse it, once it becomes a factor in the economy.
I think the rate of price inflation will slow in 2007. I think unemployment will rise above 5%. Until the yield curve inverts for 30 consecutive days, I will not call a recession, but it has that look about it.
The policies of Greenspan's FED were always inflationary, from the month he walked in until the week he walked out. That policy relentlessly forced up prices and postponed a much-needed reallocation of capital values and prices. Alan Greenspan spent his entire career at the FED warning against price inflation while pursuing a monetary policy that guaranteed price inflation.
Bernanke's FED has lowered the rhetoric against price inflation, while pursuing policies that will call price inflation to a halt and then produce price deflation within two years. But the cost of maintaining this policy will be a long recession and rising unemployment.
I don't think Bernanke or his fellow Board members are willing to pay this price. Congress would demand a reversal, which is beyond Congress's legal authority to enforce, but is well within Congress's ability to create exceedingly bad publicity for the FED, which bureaucrats never want to endure.
August 9, 2006
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