Inflation is not a problem (yet)

I've been saying for a while that the dominant underlying economic force in the United States is that of deflation. If left to its own devices the US economy would collapse into a deflationary depression and take the world economy with it. Of course, the economy has famously NOT been left to its own devices. The federal government has invested $750 billion in the banking system, issued a $700 billion stimulus package AND forecast deficits of 5-10% of GDP as far as the eye can see. The Fed has expanded its balance sheet by $1.25 trillion since the collapse of Lehman Brothers, with plans to expand it even more by buying long term treasury, mortgage and asset-backed debt. The Fed Funds rate has been set at 0% to 0.25%, allowing the banking system to borrow from the Fed at very low short term rates, while risky debt is yielding much higher rates, fattening bank profits (before asset write-downs).

We are in uncharted economic waters, and in a system as complex as the world economy, it is hard to separate signal from noise in terms of what effects our policies will have and how they get transmitted through the economy. In economics class, most rules start with the assumption "all other things being equal", which in the real world is never true. In fact, the economy is in a constant state of disequilibrium, but with a powerful force that seeks to restore equilibrium in some things while creating more disequilibrium in others. In my view, the easiest way to make money is to spot the disequilibrium that faces the path of least resistance to be corrected and to bet on that correction.

The correction occurring right now is the massive unwinding of the inflationary housing bubble. The unwinding of a debt-fuelled inflationary bubble comes in the form of debt deflation. Because an unchecked debt deflation is what caused the Great Depression, today's economists have been taught to fight debt deflation at all costs. Thus we are recapitalizing the banks, printing money like mad and engaging in deficit spending. In other words, we are fighting a deflation specific to real estate (and to a lesser extent, LBOs) with a generalized inflation. The inflationary policies are alarming to many, even prompting a recent round of speculation that the US may lose its "AAA" credit rating. So far, however, market signals are telling us that the greatest set of inflationary policies ever devised has so far only created "reflation", or the undoing of deflation, and are not yet signaling high inflation. The Fed and Congress will need to be vigilant about withdrawing this inflationary stimulus if the market signals do start pointing to inflation, however. The signals I watch are the TIPS spread, the Treasury yield curve, the value of the dollar and the price of gold.

The TIPS spread

The easiest way to look at the market's inflation expectations is with the TIPS spread, or the spread between the yield on a Treasury Inflation Protected Security and a nominal Treasury bond.

As of Memorial Day 2009, the nominal 5-year bond yield is 2.14%, the 10-year is 3.37% and the 30-year is 4.32%. The 5-year TIPS yield is 1.34%, the 10-year is 1.63% and the 30-year is 2.12%. That means the 5-year market inflation assumption is 0.8%, the 10-year assumption is 1.74% and the 30-year is 2.2%. Since the Fed's implicit inflation target is 2% and in historical practice it has been 2.5%, inflation would appear to be well in hand.

However, those numbers assume that inflation averages 0.8% for the next 5 years, jumps to 2.7% for years 5-10, and then settles back down to 2.4% for years 10-30. Not terrible, but probably a pretty good assumption that inflation will accelerate after the eventual recovery.

Treasury Bond Yields

If you assume the Fed has a long term goal of 2% inflation, the equilibrium treasury yield curve would look like a Fed Funds rate of 2.75%, a two-year of 3%, a five-year of 3.5%, a 10-year of 4% and a 30-year of 4.5%. I put a band of 25 basis points (0.25%) around the Fed Funds and the two-year and a 50 basis point (0.5%) band around the 5-30 years, just to account for the fact that this isn't an exact science. (I use 2.75% or the Fed Funds rate, because that leaves a zero percent return after inflation and taxes, which is all you should expect for holding riskless cash.) By this analysis, the Fed Funds rate, the 2-year (at 0.85%) and the 5 year are well below their equilibrium rates, the 10-year is approaching its equilibrium range and the 30-year is in its equilibrium range.

The current yield curve implies that inflation and the Fed Funds rate will be low for several years, but that reflation will be successful but controlled and that is what's being reflected in the 10-year and 30-year spreads.

The Dollar

One problem with using treasury yields for a market indicator is that the short end of the curve is always manipulated by the Fed (and the Fed sometimes gets it wrong) and recently the Fed has even been manipulating the long end of the curve by buying Treasuries. If rates are manipulated too low by the Fed "monetizing" the Federal debt, the pressure would be relieved in the form of a weaker dollar.

When deflation is a problem, people hoard dollars to stay liquid and the dollar rises. In reflation, the dollar is pushed back into its equilibrium trading range. In inflation, the dollar bumps against the bottom of its trading range, as it did as recently as early 2008.

Nominal Major Currencies Index:

The dollar, relative to other major currencies, has been on a mild downward path (less than 1% per year) since we dropped the gold standard in 1973, if we exclude the two dollar bubbles of the mid 1980s and the late 1990s. Given that the original fixed currency values under the gold standard (Bretton Woods dollar standard, really) were set after World War II, when the US had most of the world's gold and the only major economy not devastated by the war, I'd actually say that's not a bad performance for the dollar.

In my view the equilibrium value of the major currency dollar index is between 84 and 70, with a mid-point of 77. It is currently at 79.5. While the dollar has fallen a bit in the last few weeks, it is still near the high end of its range.

Real Broad Dollar Index:

Against all currencies (in real terms), including emerging market currencies, the dollar as of the end of April was at 96, just above its long term equilibrium range of 85-95. Given the action so far in May, it's probably now in the range, but close to the top of the range. This means people are no longer hoarding dollars in a deflationary manner, but it also means inflation is not out of control.

Gold and commodities

Of course nearly every country in the world is printing money and running large deficits to get through this crisis. When all currencies are being inflated, they can all drop together, even while the dollar appears to be in its trading range. When all currencies are weak, the price of gold and other hard commodities rise as investors lose faith in paper assets and move their money to assets that protect the long run value of their hard earned savings. Gold, while it pays no interest, will at least in the long term (since the dawn of man, really) serve as a store of value as long as it's not bought during a speculative fervor.

Gold price in dollars:

The value of the dollar has declined from 1/35th of an ounce of gold during the Depression to around 1/150th of an ounce in the mid 1970s, to an average of about 1/375th from the mid-1980s to the mid-1990s to about 1/900th of an ounce today. That means the dollar today is worth just 3.9% of what it was during the Depression and World War II.

The price of gold rose from $260 an ounce in 2001, when the dollar was strong and real interest rates were high, to $1000 per ounce during the recent inflationary fervor in early 2008. Had severe deflation taken hold, I would have expected gold to fall back to under $600 per ounce. Instead, it has stayed high (generally in the $850 to $950 per ounce range), and it is currently at $955. If gold remains under $1,000 per ounce, renewed inflation (beyond what the market anticipated before the bubble burst) is probably not a problem.

Another way to look at commodities is the value of a commodity relative to gold. The "normal" price of oil, for example, during the 1980s and 1990s, was $20 per barrel. During that period the normal price of gold was $375 per ounce. If the new normal price of gold is $900/oz, the new normal price of oil is $48 per barrel. Today it is at $60…probably overvalued at bit, but not signaling massive inflation.


The market signals are not currently pointing to inflations' being a problem for the US. That said, the Fed must be vigilant about moving rates to equilibrium or above when the signals start pointing to an inflation problem. The signals pointed to inflation in 2004-2008 and the Fed was slow to respond. Now the Federal government is in on the action as well. Congress will need to rein in it spending when the time is right. Unfortunately, Congress' track record has not always been strong in that regard.

Hot and Cold on Obamanomics

While my blog is not a blog about politics, it is about economics, and you can't talk about economics these days without talking about politics. The big investment opportunities are often directly or indirectly caused by distortions in government policy and the unwinding of those distortions. That's not to say I think government involvement in the economy is bad per se. It's just that the federal government is such a large actor and (in the case of the United States) not governed by normal rules of business and economics, its actions have an outsized effect on the economy.

As I noted in Part IV of my 2009 economics series, the American people have done a good job managing fiscal policy over the past 70 years by switching out presidents and congressional control. Obama's willingness to run large deficits via large doses of government spending is appropriate for the current deflationary environment, and it makes sense to back him up with Democratic majorities. It was appropriate to elect Bush in 2000, to ease fiscal policy via tax cuts, given the weakness in business investment, budget surplus and strong dollar at the time. I was appropriate to elect Clinton in 1992 as a moderate progressive to focus on policies that supported consumer spending after 12 years of "supply-side" Republican rule, but then also appropriate to put in a Republican congress in 1994 to focus on deficit reduction after 14 years of high deficits. I could keep going back, but you get the picture. Circumstances change frequently, but the political parties change ideology much more slowly, so the people conduct economic management for the parties by changing them in and out of power.

Personally, I'd prefer to see us move to a more balanced policy conducted on a bipartisan basis. Otherwise we're doomed to these wild swings in economic fortunes that keep requiring bigger and bigger government responses to keep the game going. As I've frequently stated, I think we're in overtime of the current game of bubble surfing that has been building since the end of World War II. I thought Obama had the chance to start a new game (and he still has that chance), but so far he seems focused on keeping the old game going. So we surf from the Great Society bubble to the 1970s inflation bubble to the Reaganomics bubble to the Dot-Com bubble to the real estate/globalization bubble to Obama's government spending bubble, racking up more and more debt as we go. In the meantime the average American is forced to endure wild swings in inflation, interest rates, stock values and real estate values. Such swings are great for hedge funds managers and Wall Street financiers, but they are tough for working stiffs who just want to work hard and provide a decent life for their family.

With that said, here is my scorecard on Obamanomics so far:

  • Financial Crisis – As I've noted previously, I generally approve of the way the Obama administration has handled the financial crisis, although I actually would have been harder on the banks. The stress tests had too low a standard in my opinion. In my analysis, I thought the banks needed another $1-1.2 trillion to shore up their balance sheets. The Treasury thinks the banks need $75 billion. Why the difference? I thought the banks should have equity equal to 10% of their assets, while the Treasury is targeting equity equal to 4% of assets. 25 to 1 leverage seems inappropriately low to me, given the highly uncertain environment facing real estate and business loans over the next two years. The Administration has lost the political will to ask for more money, so it's hoping we can skate by with what they already have. My suspicion is that within 4-5 years we'll be revisiting this issue. If we were more willing to wipe out private bank shareholders, the American people would have been more amenable to funding the TARP. Unfortunately, the financial industry is one of the biggest donors to both parties, so we are where we are.
  • Auto bailout – Up until recently, I have been supportive of the Administration's auto bailout policy. That is until they decided to rip up hundreds of years of bankruptcy law precedent to conduct a union giveaway at the expense of the secured creditors. It's what I'd expect out of Hugo Chavez's Venezuela, not the United States.
  • Stimulus – While I think it's unrealistic for the government to efficiently spend so much money in such a short period, their heart is in the right place on expanding the government's balance sheet to offset the decline in business investment, residential investment and consumer spending associated with the financial crisis. I would have preferred to see a smaller stimulus and more invested in the financial system (which we will get back with interest). A lot of the stimulus money being spent on "infrastructure" will be a boondoggle, but will provide a decent short-term boost to the economy.
  • Budget – The long term budget outline laid out by Obama is crazy in its deficit projections, but is focused in the right place by emphasizing health care, education, energy reform and infrastructure. It just spends too much for too long a period of time. Expect a Republican congress sometime in the next six years to rein it in.
  • Cap and Trade – As I expected, the cap and trade program proposed by Obama is quickly turning into a joke, with lobbyists battling for exemptions for utilities and manufacturers and watering down the whole thing. If the Administration had followed my advice, and just been honest about the fact that it is a carbon tax, it could have been more effective. Calling it a regressive tax would force policymakers to offset it with a repeal of the payroll tax, trading a tax on work with a tax on spending (on imported oil, no less). Such a trade off, including a big cut in the corporate tax, would appeal to liberals and conservatives alike.  Instead we get something ineffective, shaped by lobbyists and insiders, that will punish average people with no discernable effect on the environment, all to salve the conscious of rich liberals. It would be funny if it weren't so sad.

Overall the Administration is effectively responding to crisis, while missing some of the opportunity to put this nation on sounder long term footing.

The New Deal’s great mistake

Watching the slow-motion disaster that is the US-based auto industry, I think it is worth understanding just how we got into this mess.

Back in the day, before World War II, many viewed the large manufacturing concerns that dominated the economic landscape as basically a collection of machines.  Labor was locked in a titanic struggle with the owners of the machines (called Capitalists) over how to split the profits produced by those machines.  Economic theory treated assembly line labor as an undifferentiated input ("L") and production was measured as undifferentiated output ("Q" for quantity).  The companies that owned the machines were considered to be permanent entities.

The Capitalists had the upper hand in the struggle throughout the late 1800s and very early 1900s, before World War I caused the old order to unravel.  The two rising ideologies were Marxist Communism, which believed that Labor should own the machines directly, and Fascism, which believed in a state-driven socialist corporatism (in addition to some other nasty stuff).  By the early 1940s, continental Europe had fallen under the control of these two forms of government. The US and the UK threaded the needle by adopting elements of socialism while maintaining the dynamism of capitalism.

Of course I think the US got it mostly right.  However the New Deal in the US didn't completely reject the popular Marxist notion that companies are a collection of machines (aka the "means of production"), and it saddled these companies with social obligations that would eventually both do the employees a disservice and put US companies at a competitive disadvantage with foreign firms. 

This was the New Deal's great misake.  Companies are not a collection of machines.  They are evolving entities. Companies operate in a highly competitive, rapidly changing environment, with fickle consumer tastes and volatile business conditions.  Regardless of how powerful a company may seem at any given time, it is destined to disappear someday. 

The evolution of a company and its industry

In a new industry a few innovative companies will get traction with a product.  As the popularity of the product grows with the general public, more companies enter the industry.  Employment in the industry rises during this phase as companies invest in growth.

About halfway through the adoption cycle among the public, growth starts to slow.  The easy money fades and the industry gets more competitive.  Firms start merging with each other or going bankrupt.  Economies of scale start to matter, and companies focus on improving profitability rather than simply investing in growth.  Employment in the industry starts to fall.

When the industry matures (its product is fully penetrated among the public), it has probably consolidated to an oligopoly of 2-3 major companies that compete on product innovation and labor-saving investments.  Eventually, a replacement product comes along that forces the industry into permanent decline.

Given this evolutionary cycle, does it make any sense for retirees to look to a company that they may have worked for 20 years prior to support their retirement and health-care?  Why should companies be in the business of providing retirement investments and health-care in the first place?  Should workers be locked in to spending their whole careers with one company that will care for them all the way to the grave?  Should people live in fear of getting fired and losing their benefits when it is all but certain that employment in all but early-stage industries will decline over time?

Time to rethink the saftey net

The Chrysler and GM situations are this broken system playing out to the extreme.  Back in the day, the unions would threaten to strike for more pay.  Management would kick the can down the road by offering unaffordable retirement promises that would blow up on someone else's watch.  (Not unlike what Congress does with Social Security and Medicare.)  The companies support hundreds of thousands of retirees when they have tens of thousands of employees.  They have traditionally run at overly high levels of production just to support the huge number of obligations they have accrued to employees and dealers.  Today the system has finally blown up.

From the auto manufacturers down to the corner deli, the system makes no sense.  Employees should either be able to shop for their own benefits or the government should provide them.  Ideally, in my view, individuals would shop for benefits from providers that receive strong government oversight.  Either way, the last place employees should be forced to look is to their employer, who is an inherently unstable entity.  Employers get acquired, go bankrupt, and lay people off all the time.  Its hard enough for companies to compete just to survive in the marketplace, let alone to be forced to be in the health care and money management businesses as well.