In 1974, the year I started publishing my newsletter, Remnant Review, this debate was raging hot and heavy in hard-money (pro-gold) circles. This was during Ford’s recession. The stock market was in a major decline. One group was predicting imminent price deflation. This group included C.V. Myers and John Exter. The other group was predicting imminent price inflation. I was a member of this group. So was Mark Skousen. So was the late Jim McKeever. Both of them edited the now-defunct Inflation Survival Letter. We called it right. The inflation rate from 1975 to 1981 was the highest in peacetime U.S. history. Anyone who predicted deflation missed a golden opportunity.
The debate heated up again in 1981-82 during Reagan’s on-again, off-again recession. I still predicted price inflation. Prices are 80% higher today than in 1982. You can check this figure with the handy inflation calculator on the Website of the Bureau of Labor Statistics.
The U.S. economy became disinflationary under Reagan. The price level never came close to falling, but the rate of price inflation declined, 1981-89. That was the result of the Federal Reserve System’s policy not to inflate, 1979-82, which brought on the Reagan recession. But the FED did re-inflate after the Mexican bank crisis on the weekend of August 13th, 1982. In the 1990’s, after Bush’s recession, the rate of price inflation became steady at around 3% per year.
We are now in the middle of another debate over this issue. The stakes are just as high for investors.
If price inflation is in the cards, then long-term interest rates will rise. The market price of existing bonds moves inverse to the long-term interest rate. Bond holders will see the market value of their investment fall. It deflation is coming, long-term rates will fall, and bond holders will see their investment rise, unless (1) the company that issued the bonds can’t pay or goes bankrupt, or (2) its bonds get downgraded by Moody’s or some other rating service, or (3) it calls in the bonds by paying them off with money borrowed at a lower rate of interest.
Defining Terms
First, we must distinguish between monetary inflation and price inflation. (We have not seen monetary deflation and price deflation simultaneously since 1932.) Nobody denies today that the money supply is being inflated by the FED. There is only a debate over how much: higher than normal or wildly higher than normal.
Second, the debate centers around prices. Are prices in general headed higher or lower over the next two or three years? Or are we in a disinflationary period again? Bond traders in November concluded that long-term rates are headed higher. The price of T-bonds fell sharply. It could be that bond traders expect higher rates because of rising risk, or rising price inflation, or falling demand for long-term bonds. They didn’t say. They just hammered the price of bonds.
To begin to deal with the inflation vs. deflation issue, we have to get our terminology straight. We also have to have some idea of the statistical indicators that are available. There are lots of them.
I don’t want to bore you with a lot of extraneous material, but I also don’t want you to get sucked in by any analyst who ignores key indicators that provide evidence against his conclusion. If you have some idea of what the issues are, you will be able to think through the reports of the financial press.
We are all learning. A lot of experts lost a lot of money over the last 40 days because long-term interest rates went up unexpectedly, and bond prices crashed. There are lots of imponderables. My goal is not to confuse you, but to help you think straight.
The Federal Funds Rate
The Federal Reserve System has lowered the federal funds rate eleven times since January 3, 2001. The federal funds rate applies to inter-bank overnight loans. It is the shortest of short-term loans. The rate is now 1.75%.
By all measures, the rate of consumer price inflation is now above 1.75%. This situation may not last, of course. There are deflationary pressures worldwide.
The federal funds rate is now the lowest it has been since July, 1961.
Some banks lowered their prime lending rate to 4.75%, the lowest since November, 1965.
The FED also lowered the discount window rate — the FED’s direct loans to banks — to 1.25%. This is the lowest in the post-World War II era. But this is basically an irrelevant rate except in times of major crisis. Banks rarely borrow from the FED. If they do, they are subject to detailed questions as to why they are borrowing. Look at the chart for 2001. Only in September, the month of the attack, did banks borrow money to any degree. See the top chart.
http://www.stls.frb.org/docs/publications/usfd/page10.pdf
The FED cannot lower rates just by saying, “Today, there will be lower rates.” It has to back up the announcement with new money. If banks borrow from each other at a lower rate, money must change digital hands. If the lending banks don’t offer enough money to meet demand at the lower rate, the rate will rise.
There is more demanded at a lower price, other things being equal. So, the key factor in the FED’s arsenal is its ability to supply additional money. The FED has to make new money available to meet increased demand at the new, lower rate.
Creating Money
How does the FED do this? By creating new digital money and releasing it into the economy. It releases it, not like Santa brings free toys, but by purchasing assets. Legally, these assets can be anything the FED wants to buy, but normally they are U.S. government debt instruments.
When the FED buys an asset, its reserves increase. It spends this newly created money when it buys from the 20 or so private bond trading firms that handle the transactions. They in turn pay the Treasury for the bonds they sold to the FED, and the Treasury spends the money. Those who receive this newly created money deposit it in their banks. Their banks now have increased deposits, so they can lend money. Down goes the federal funds rate.
The St. Louis FED charts what it calls the adjusted monetary base. This records the increase or decrease of monetary assets owned by the FED. The larger the base, the larger the supply of legal reserves for the banking system to use in pyramiding its fractional reserve credit money.
We see a steady increase over the last 12 months. From December 13, 2000 until December 12, 2001, the adjusted monetary base grew by 8.3%. There was a big increase immediately after the attack on September 11, but then it was reversed. Thus, we see a spike. http://www.stls.frb.org/docs/publications/usfd/page2.pdf
From October 17 until December 12, the increase was a piddly 2.2%. This indicates that the FED is taking a steady though inflationary course: 8% per annum increase of the basic money supply.
The federal funds rate was 6.5% on January 3. It is now 1.75%. That is a rate cut of 73%. That is a huge reduction. I can’t recall anything like it in this brief a period. So, we might ask, how did the FED achieve a fall in the federal funds rate of this magnitude? If the FED was not pouring in new money by the boat load, especially during the last two months, how did it force down rates this much? Or did it?
If the supply side of the money equation offers no plausible answer, then we should attribute most of the fall to falling demand for loans. What this means is that short-term rates fell in 2001 mainly because the economy was falling. The demand for loans must have been falling. Falling demand for loans produces a falling price to “rent the money,” i.e., the interest rate.
If my hypothesis is correct, then we should see evidence of a decline in commercial loans. This is exactly what we see. Take a look at two charts. The top chart is for commercial paper (CD’s) of nonfinancial corporations. What have they been issuing this year to the public to finance their short-term operations? In mid-January, they had outstanding about $330 billion in debt certificates. By mid-December, this was down to the $210 billion range. A slump? You’d better believe it!
The second chart, commercial and industrial loans, peaked in late February at over $1.11 trillion. By late November, this was down to $1.032 trillion.
http://www.stls.frb.org/docs/publications/usfd/page11.pdf
This indicates that, despite falling short-term rates, businesses have been reducing their short-term debt load. This means that at a lower cost (interest rate), there has been reduced demand.
How can this be? Shouldn’t the quantity demanded rise when the price falls? Yes, but only with the economist’s escape hatch: “other things being equal.” But other things are never equal in this world. What has not remained constant this year is the U.S. economy. It fell into recession in March, according to the official pronouncement of the unofficial pronouncer of recessions, the privately funded National Bureau of Economic Research.
Businesses are not rushing down to borrow lots of money despite lower rates. Managers see that any increased debt must be paid off out of revenues, and expected revenues are falling. I feel the same way. I am not buying a new 2002 model car just because I can borrow money at 0% interest. That’s because I would have to pay off the debt. In this economy — in any economy, short of mass inflation — I don’t want any debt for historically depreciating assets.
If businesses are not borrowing all of the newly created money, where is the money going? It’s going into securities. This doesn’t mean shares in the S&P 500. It means U.S. government debt certificates. You can see the trends. Bank credit is heading down. So are loans and leases. Commercial and industrial loans are now negative. But investment securities is rising.
http://www.stls.frb.org/docs/publications/mt/page14.pdf
I have been speaking of what the FED does directly, and what banks do to lend the money that the FED makes available. When you want to know what FED policy has been, look at the adjusted monetary base. This tells you whether the FED has bought or sold assets. This is what adds or reduces bank reserves to the commercial banking system. In other words, this is the most significant tool of monetary policy that the FED has.
The evidence I have presented here indicates that the fall in the federal funds rate has been caused mainly by the effect of the recession: falling demand by banks for money to loan out. There are fewer solvent customers for banks to lend money to. The FED has taken credit for this fall in short-term rates — credit for credit, you might say — but it has been sailing with the wind, not against it.
Multiple Measures of Money
How the economy uses these reserves is not controlled by the FED. That is why there are so many concepts for money: M-1, M-2, M-3, and MZM. These figures usually rise or fall in the same direction, but not at the same rate.
http://www.stls.frb.org/docs/publications/mt/page4.pdf
This is why forecasters who try to discern FED policy by following one of these monetary aggregates have a problem. Greenspan and most monetary economists say that money, as it actually circulates in the real world, is not easily defined.
The chart for money of zero maturity (MZM) is off the chart, as they say. It is rising rapidly, although not so rapidly as it in September.
http://www.stls.frb.org/docs/publications/usfd/page3.pdf
M-1 is more easily understood: checking accounts and currency. This is the money that you and I can spend immediately. It has risen over the last year from $1.1 trillion to $1.181 trillion — less than 8%, or about what the adjusted monetary base has risen.
http://www.stls.frb.org/docs/publications/usfd/page3.pdf
Think about this. The FED has increased legal reserves for commercial banks by 8%. Immediately spendable money has risen slightly less than this. What has happened to consumer prices?
Multiple Measures of Prices
Just as there are multiple measures of money, so are there multiple measures of prices: producer prices, commodity prices, consumer prices. There are even multiple measures of consumer prices.
One measure is the most common: the consumer price index (CPI). It measures a “basket of goods and services.” It also weighs their importance. Subjective evaluations by economists enter at this point. Let the index buyer beware!
There is the CPI without food and energy. This index is more stable because food and energy prices are volatile. They rise and fall rapidly in large swings. They may not tell you what the economy is doing as a whole.
There is also a more recent measure, median CPI. This index was announced in 1994 by two economists at the Cleveland FED. This index removes the prices that have swung most wildly, either up or down. The median CPI contains housing, which is fairly stable, but not anything that rose or fell on the outer limits of the prices surveyed.
There is growing acceptance among economic forecasters of the possibility — not yet a fact — that the median CPI is a better predictor of what the trend of prices is, assuming that the FED doesn’t switch monetary policies. Example: if the FED is inflating, then the median CPI, if it is going up, will be a better indicator of future price trends than the CPI is. On the other hand, if the median CPI is rising, but the FED is not inflating, then it may not be as good an indicator as the CPI. For a simple, one-page discussion of CPI vs. median CPI, click here:
http://www.stls.frb.org/docs/publications/net/1999/cover10.pdf
These days, I am partial to the median CPI because FED policy is clearly inflationary, i.e., anti-deflationary.
The median CPI, November 2000 to November 2001, increased by 3.9%. June to June, it was 3.6%.
http://www.clev.frb.org/Research/mcpipr.htm
The median CPI for November, 2001, if extended for the next 12 months, will produce an increase of 3.5%. (Look at the bottom of the table, right-hand number.)
http://www.clev.frb.org/Research/mcpi.txt
Now let’s look at the standard CPI. Prices have risen by 2.7% per annum since a year ago. Prices were rising at 3.4% per annum until summer began. The recession began in March. So, there is downward pressure on prices, but nothing like deflation.
http://www.stls.frb.org/docs/publications/net/page15.pdf
For a handy chart that lets you see the discrepancy between these two measures, see the chart, “12-month percent change.” This is a very useful collection of charts. On page 2, we are told the high and low items that the index-builders have excluded from median CPI. Another interesting chart in on page 2: the comparison between core commodities and core services. The price change of core commodities is now zero, year to year. The price level of core services has been rising: from 2.5% per annum in late 1999 to 3.75% today. I strongly suggest that you print out this document. You need to see this increase to appreciate it.
http://www.clev.frb.org/Research/Et2001/1201/infpri.pdf
Both of these CPI measures indicate that the upward movement of prices is now slowing or will very soon. This is especially true of the CPI. But neither measure indicates anything like price deflation. To get the U.S. economy into actual price deflation would take not only a worldwide recession — which we’ve got — but also an unprecedented reversal of pricing in services, which constitute the bulk of the U.S. economy. Services are far more resistant to price-cutting than commodity prices or manufactured goods. People resist getting their wages cut. Also, imported services are few. There are data-entry firms in India that are sent data from the United States by the Internet. They use low-paid workers to key in the data, and then send back the keyed-in data the next day. But these kinds of services are rare. Most services are local. Some are regional. Some are national. Foreign competition is minimal.
Prices and Money
Why aren’t prices rising as fast as the money supply is (8%)? One standard explanation is that the prices of imported goods are falling. Foreign manufacturers are cutting prices because their economies are in recession. Also, the dollar is rising in relation to Asian currencies. Second, the velocity of money is falling. People are making fewer purchases per unit of time. The velocity of money has been going on for over four years, but the rate of decline has accelerated since mid-2000.
[Sorry; the St. Louis FED tracks the velocity of MZM and M-2, which is checking accounts, currency, and savings accounts. They don’t track the velocity of M-1, which would make more sense.]
How is investment spending going? Down. Way down. Down across the boards.
http://www.stls.frb.org/docs/publications/net/page15.pdf
Businessmen are not optimistic about the near-term future of the economy.
Good News and Bad News
So, where is the good news? The good news is that the dollar is rising against the yen and every other currency.
The bad news associated with this is that Japanese imports are getting cheaper every time the yen falls. Japan is the bellwether Asian currency. The other Asian nations will follow Japan’s lead in order to avoid getting priced out of the market.
Recently, my friend Bob Anderson was in a Costco discount store. His wife pointed to a pair of irons. One cost $79. It was imported from Germany. The other cost $23. It was imported from China. Westward the course of price-cutting goes!
For a consumer with a job, it’s fat city. For a manufacturer, it’s bad moon rising.
There is no way to put a halt to the movement of manufacturing out of America unless we pass laws against the right of consumers to buy what they want, i.e., tariffs and import quotas. American consumers are making the decision to push manufacturing off-shore, purchase by purchase. Price competition counts for a lot in their eyes. They are voting with their money against high-price items. Today, jointly owned American-Mexican maquiladora industries on Mexico’s side of the border are shutting down. Mexican wages close to the U.S. border are now too high. These companies cannot compete with Asia.
The recession is worldwide. Manufacturers all over the world are losing money and even going bankrupt. Yet the U.S. economy appears to be immune. There are lots of cars in the malls’ parking lots. But there were pre-Christmas discounts aplenty inside these malls. This year will not prove to have been a good Christmas for retailers. I would not want to be the owner of a local toy store.
The good news is that federally insured banks can borrow money cheap. The bad news is that interest rates are so low that uninsured money-market funds can barely meet expenses after paying depositors a minimal rate of interest (under 2%). If rates remain this low, we could see that most dreaded of money-market fund events, funds that “break a buck” — fail to retain net share value of $1. That would create all sorts of uncertainty. Sean Corrigan, whose judgment I respect, writes this:
This has already prompted the SEC to make discreet enquiries about what these funds propose to do should net returns become negative. That this is a matter with far-reaching implications can be seen in that the $2.35 trillion held in this form — $1.1 trillion of that in retail accounts — is marketed with the so-far untested promise that the value of such assets will “never break the buck.”This means that they promise always to return principal intact and, given that it is usual for them to offer checking facilities, this pledge (whether able to be honored in extremis or not) underpins the widespread perception that these represent money to their holders, thus making these negative returns — i.e., losses — potentially a matter of great significance.
Some funds have said they will temporarily waive fees, hoping for the best, but others intend to return the monies to clients forthwith. Thus, even if a panicked wave of forced redemptions is not forthcoming, a major and possibly disruptive shift in monetary holdings may still be in store.
Certainly these trends are beginning to suggest that, unless Greenspan’s Fed is willing to suspend or adulterate a further raft of prudential regulations, the rapidly deteriorating productive structure, being weakened as we write by yet more improvident consumption, will increasingly constrain the credit multipliers in the system. That would throw all forms of risky assets — from lower-grade bonds and paper to equities — into disarray once the cessation of an accelerating money supply forced a renewed focus on the underlying fundamentals.
Then we would be back where we started, having to endure a major relapse in terms of the real economy and a further plunge in the value of our paper collateral, only this time with another several hundred billion dollars in unserviceable liabilities around our necks.
I think we are in a disinflationary period. But there are limits to what the FED can do to keep us where we are. If the FED pushes the federal funds rate to 1% or less and keeps it there, we will see money market funds “break the buck.” This could create serious uncertainty among investors. But if the FED slows the increase in the money supply, the possibility of a major recession increases. This could produce price deflation.
The FED, as usual, is walking a tightrope. This tightrope is suspended over fog. The wind is rising. With the highly leveraged derivatives market so huge ($100 trillion?), no one knows how high the tightrope is. Break the derivatives’ market in a wave of cross-linked defaults, and price deflation becomes a real possibility. When prices are falling, currency is appreciating in value, tax-free.
For now, I’m sticking with a prediction of lower price inflation, i.e., disinflation. The core rate of price inflation will fall, but the index will not become negative in the near future.
But what about the phenomenon known as “pushing on a string”? Will this thwart the FED’s policy of monetary inflation? I will tackle that conceptual curiosity tomorrow.
December 26 , 2001
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