Fed Poker II - Inflation Revisited

By: Randolph Buss | Mon, Oct 24, 2005
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More Evidential Considerations

In recently having perused a book on Kondratieff cycles, I was reminded that nearly all the K-cycles were accompanied by parallel technological advances of some sort which increased, however dramatically, the productivity at the given time. One could therefore argue that the main productivity gains of the last 20 years to worldwide business, since the coming online of personal computers to the mainstream and with it the ubiquitous usage from both consumer and businesses, that this technolgical advancement may be coming to slowing down and with it a concurrent Autumn to Winter change in the K-cycle. By that I do not mean that technology is stopping, but merely that the rate of change and its follow-on productivity gains may fall with respect to that of previous levels.

In looking at the excellent graphic provided by Ian Gordon, with whom I spoke last year on this subject at a European conference, he has labelled the chart with a few dates. The dates from 1949 to 2000 show an average of 17 years between seasons, whereby here I must emphasize it is an average and therefore just a gross guideline.


Source: Ian Gordon, Long Wave Analyst

I would nevertheless argue that this graphic may be potentially "corrupted" due to monetary policy. This hypothesis is simply based on the fact that US Federal Reserve monetary policy since the 1920s has been altogether subjected to various "flavours" from Fisher to Keynes with likely influences of Friedman, Stiegler and others. Hence, we can logically suppose that business cycles, or K-Cycle seasons, are not totally insensitive to such monetary backdrops. In referencing a Working Paper¹ from Prof. Antony Mueller, Adjunct Scholar of the Ludwig von Mises Institute, he quotes:

Since its inception, modern central banking has gone through various fashions and has adopted opposing paradigms. In the 1920s, the U.S. central bank had a deeply Fisherian character, as Irving Fisher laid it out by promoting the central concepts of modern monetary policy such as the "price level" (Fisher 1922). In the great wars of the first half of the 20 th century, central banking has adopted a political character and its role became that of supporting the war efforts. In the 1960s and 1970s, many central banks adopted a Keynesian perspective only to make a 180-degree turnaround in the late 1970s when they embarked upon the monetarist experiment. [Fed Gov. Volcker's high interest rates - R. Buss] Since the late 1980s most central banks, and prominently the Federal Reserve System, have turned away from the monetarist quantity formula and have focused on "price-level stability" in the form of a pragmatic inflation targeting approach. Central banking has gone full circle and since the 1990s it has become "Fisherian" again.

Although this may sound like a bunch of mumbo-jumbo from the stacks of some crusty old university, it is in fact, highly relevant. The Fed is not just "fooling around" like some staggering alcoholic - although I'm sure some would violently disagree - the Fed has a strategy in mind, even though that strategy may in fact be long-term detrimental to monetary stability as we currently know it, or it may turn out fine, we don't know at this juncture and neither does the Fed. Equally, nobody ever said the Fed was apolitical, and currently the US is facing longer-term military "endeavours" abroad which must be taken into account with regard to funding while maintaining price stability at home. Fisherian indeed.

So when looking at the K-Cycle Autumn description above, we see obvious signs of both Autumn and Winter happening in parallel, and some would even argue that we are facing Summer's runaway inflation, which then puts into question the entire K-Cycle ordering being relevant in today's highly dynamic and very interconnected world. Remember that past K-Cycles were not likely subjected to such intense globalisation forces and were to a large part, historically seen, theorized at a time of gold backed currencies and trade. This is no longer true today, so at best, I see the K-Cycle as being historically interesting but have my doubts as to it being 100% relevant in today's more complex financial world. I am not dismissing it but rather keep it as a valuable guideline.

Getting back to the question of inflation revisited. I again quote from Prof. Mueller's Working Paper:

Under the condition of major cost reductions due to intensive technological progress or because cheaper factors of production become available, a monetary policy oriented at price stability is prone to initiate an unsustainable boom. Instead of allowing deflation to run its course, monetary authorities pursue so-called stabilization policies. This way they push the economy on a path to debt accumulation. The more intensive the technological advances and the cost reductions will be, and the longer the period will continue when monetary policy holds down the interest rate, the more the economy will be induced to increase its debt levels. The size of the debt level relative to the productive base at the peak of the boom will make monetary policy ineffective once the contraction phase takes hold.

In the case of a dearth of productivity gains and under the condition of rising labor costs, the inflationary bias of modern central banks produces inflation and stagflation, as expansive monetary policy feeds directly into higher consumer prices. It is mainly under the conditions of high productivity gains or when other factors bring down production costs on a large scale that central banks have an easy shot to achieve "price-level stability" or rather hold the inflation rate within the established target. This way, however, central banks are misled about the consequence of monetary expansion, as it does not yet show up right away in the consumer price index. By ignoring the role of the interest rate on the capital structure, monetary policy amplifies the economic expansion that began on the supply side and turns it into a demand-driven boom based on credit creation.

The critical stage and the turning point take place when the phase of concentrated technological progress ends and/or when an adverse supply-shock occurs. Then, the foundation on which the pyramid of debt was erected breaks away. Debt-free growth could have been achieved if the central bank had let work out the short-lived deflationary episode, but instead the monetary authority, in their endeavors to fight deflation, have created a credit driven boom. At the first stage of the monetary expansion, the managed interest rate produces an economic boom; at the peak of the boom, the debt-load has made the economy vulnerable to adverse supply shocks. Shocks that would hardly affect a robust economy now represent a threat. Central bank management becomes increasingly precarious and the tendency increases to fight as long as possible against any potential downturn with further increases of the money supply.

In terms of the capital structure of the economy (Garrison 2001, 2005), both, the goods nearer to the consumption side and those nearer to the investment side with a larger time horizons get the main incentives from monetary expansion. For the consumer, consumption goods become more easily attainable, while for businesses the acquisition of better capital goods that render higher productivity can be financed more easily. With authentic savings, savers reduce their potential consumption and provide funds for investment and/or consumption by the credit takers. With monetary expansion, more savings appear to be available than there are in terms of the availability of resources, and demand for investment goods (particularly at the early stages of the production process) will increase along with the demand for consumer goods.

At the end of the boom phase, productivity gains will peter out or adverse supply side shocks will occur that no longer can be easily absorbed. With the absence of compensating productivity gains, monetary impulses now feed directly into the goods prices. In the model the aggregate supply curve moves to the left. When central banks continue with monetary expansion, inflation will result. With inflation rising, the monetary multiplier and the velocity of circulation tend to increase and drive furthermore the price level upward. When instead central banks try to counter the higher price level, a contraction of the monetary multiplier and the velocity of circulation will amplify the restrictive stance of monetary policy.

With respect to the last highlighted sentence, is this what we are currently seeing? Even as productivity gains may be waning with respect to technology, the last gasp may be taking shape in the form of "global enterprises" which outsource manufacturing to low-wage countries. Although this may be considered a productivity gain of sorts, it is made on and at the expense to internal capital investment. If long-term internal investment is neglected for shorter term profitability, then this may cause the company to be a stock market darling, but the productive capability more or less resembles an empty shell in terms of sustainability and is subjected to the fiscal and social vagaries of the country in question, likely SE Asia or elsewhere.

Fed's Viewpoint

As to whether we are witnessing inflation or not, we have done further research and reading and found that even the Federal Reserve sees inflation in the short term but less so in the longer term. In referencing a piece from the Federal Reserve's own research [2] we were "highly amused" at the following paragraph

Inflation expectations give a reading of how credible the public believes monetary policymakers are in their commitment to fight inflation; as a result these expectations are an important gauge used in the practice of monetary policy. That is, if the public believes monetary policymakers are credible in their stated goal of keeping inflation low and stable, then inflation expectations will stay low and stable. One reason credibility is important is that containing inflation expectations can be a first step in containing inflation itself. This is because expectations of higher future inflation might be negotiated into various sorts of pricing contracts, such as labor contracts, thereby creating the expected inflation.

Which is truly incredulous, for all its infinite wisdom and history, the Fed seems to believe that the consumer is in fact the one responsible for inflation. If he/she believes it, then it will come about, if not, it won't. So, now we know. Have they divorced themselves completely from the effects of their own monetary policy and left it in the hands of consumers? According to a 20 year study, the Michigan Survey of Consumers has been shown to be as accurate as those produced by professional forecasters. Thus we now see, that consumers see short term inflation here and now but do not foresee it in the future. My question is, is this a case of simply: a) wishful thinking on part of the consumer, b) an illiterate consumer as to the effects of Fed induced liquidity, or c) both of the above?


Source: Federal Reserve


Source: Federal Reserve

The final things we look at are the consumer interest rates. As can be seen by chart below, despite the current trend in place of continuing FFR (Fed Funds Rate) incremental rate hikes, the true (real) interest rates have been and remained negative since mid 2002. If we are to take the Fed's FOMC statements seriously and the recent statements from Greenspan regarding the asset markets (bubble) and removing "accommodation" in the marketplace, then surely we must foresee considerable rate increases in order to at least get us back to par (0 level), since obviously inflation (CPI) is eating into the current FFR.

If the consumer index survey (Michigan) shown above, is seen as a valid indicator of inflation, as apparently it is, then the FFR must be seen to rise rates considerably in order for the accommodative interest rates to be removed from the consumer, i.e. rates must rise considerably in order for asset markets and continued housing speculation to be effectively defeated, or at least engaged head on.


Source: Federal Reserve

In conclusion, despite what K-Cycle Season we want to call it, be it Autumn or Winter or a combination thereof, one of the most important points to remember now is what the 1-3 year outlook suggests for our investment portfolio. I believe the evidence is pointing to further increased inflation no matter what the consumer thinks or not. The liquidity overhang caused by the feed through mechanism of negative real interest rates on the price of goods can only mean more easy money chasing a finite amount of goods. Consider also that lag times are involved with regard to policy change. Combining this monetary outlook with the increased demand for real / commodity goods in Asian economies and we have the making for non-negligible if not considerable inflation. I am not talking yet about a hyperinflationary backdrop as I believe that could still be much further along in the pipeline, if ever. The potential exists of course, but still a lot of water must pass down the Rhine River before we can begin to contemplate that outlook seriously.

To summarize from [1]:

Great economic booms are characterized by high productivity gains due to new technology and often by a concurrent increase in the supply of cheap labor. By not allowing deflation to run its course under these conditions, central banks boost the boom even when they meet their inflation target. They provide ample liquidity in a situation where deflation would be required. The expansion of the money supply beyond authentic savings comes along with increasing debt levels. In such a situation, manufactured by central banks, when an excessive debt level relative to the productive base has been reached, deflation indeed becomes a problem. In a low-debt economy, the positive effects of deflation in terms of increased purchasing power outweigh its negative side and will be beneficial. In a high-debt economy, deflation becomes vicious. Therefore, modern central banks will be inclined to make the debt surge go on as far and as long as they can.

As we have seen in the last Letter - Fed Poker, 19 October, most consumers are now considerably both into debt and have zero savings. This might be a recipe for consumer and national disaster. The ball is now squarely in the Fed's court to do something accordingly. The biggest short term "if" I see is who will now take over the reigns at the Fed upon Mr. Greenspan's departure. This will be a delicate call at a time of great imbalances.

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I now feel that this further explains my outlook and position on what we may soon be facing with regard to the Fed and their strategy. Nothing is a given in the investment business and we must constantly observe to recalibrate the outlook.

As quoted by the economist John K. Galbraith, who said, "Over all history, money has oppressed people in one of two ways: either it has been abundant and very unreliable, or reliable and very scarce."

Ps. I think we are now in the "abundant and very unreliable" phase...

References:
¹ Mueller, Antony (2005): Monetary Policy in a Hayekian Supply Side Model
² Federal Reserve (2005): Are Inflation Expectations Rising from the Ashes?

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Randolph Buss

Author: Randolph Buss

Randolph Buss
Berlin, Germany
www.dinl.net

Randolph Buss, currently works in portfolio & asset management | commodity fund advisory & management | macro investment research as editor and publisher of his newsletter read in over 45 countries.

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