Latest Letter : Fed Poker
Randolph Buss, © copyright 2005
My Cross Questioning
I continue to play devil's advocate with myself as I mull back and forth the pros and cons regarding the ongoing question of whether inflationary or deflationary tendencies await us in the future; everybody seems to have an opinion on this.
After having re-read a number of historical passages along with more contemporary articles, the verdict can only be, I believe, placed into categories of subjectiveness for individuals but based nevertheless on real objective measures of monetary policy.
An individual having the correct monetary assets at a time of deflation will greatly prosper whereas those holding improper assets will likely fail miserably.
This is true of all business cycles, e.g. a Kondratieff 4-Seasons view of cyclical investment seasons verses which financial instruments may be better during the given season. Even now, many argue as to what season we are currently in and therefore what assets or instruments are best to be holding. Obviously many think buying expensive homes on credit is a winner, many are into bonds and others still are dyed in the wool gold and oil bugs. Besides ones "preferred" asset class, the real (hidden) story remains within the macro backdrop and must be further investigated based on current monetary policy.
To be honest, after reading A LOT of material, the proof of key relationships lies directly in the "chart pudding", as it were. Looking at the housing situation below, we see that since 1970 the houses for sale in the US, taking that as a broad societal indicator of economic pursuit and well-being, the chart becomes subjected to a sustained incline showing no signs of softening or rolling over at present. This is highly unusual in that we could surmise that broad societal behaviour has not drastically changed in that time period with respect to housing. Looking at the very important 10yr. Treasury rate, we see some cross correlation especially at the late 1970s early 1980s peak when interest rates were sky high. Since the time of Fed Governor Volcker and Reaganomics the 10 yr. has been falling.
Yet, we see the number of homes and home prices continually rising and in the past 35 years the average home price has risen 1000% or 10 times. I would wager that most average-worker salaries have not kept pace with that monetary fact.
We know that inflation is caused by an expansion in the quantity of money just as deflation is caused by shrinkage in the quantity of money. Therefore, just to set things straight, we must get the cause and effect nailed down. An increase in overall prices at the petrol station or in the supermarket is not inflation. That is simply price swings which may be caused by supply & demand in the marketplace, e.g. oil supplies are scarce, therefore prices rise, or harvests fail and vegetables are more expensive. This is very noticeable in consumables like PCs and printers. They have dropped dramatically in price. Nobody is screaming about deflation. These are falling in price due to factors like consumer demand, component prices and market saturation. They are not falling in price because nobody has any money.
The interesting facts in the charts below show that indeed, the consumer is strapped for money on both ends even as housing prices continue to climb, which is counterintuitive, since if one has no money, how could prices for expensive items continue to climb incessantly? Both the personal savings rate and the financial obligations as a percentage of disposable income show horrific developments over the last 30 years even as housing prices have increased by 1000% percent. This simply means that persons are farther and farther in debt and have no savings cushion to speak of.
How can this be? Some would argue that these are just numbers and do not show the true robustness and flexibility of the US economy. I beg to differ. Facts are facts and cannot be simply distorted or talked away. A very important thing to remember is that in other economies shrinkage often sets in and/or personal savings must increase in order to make up the difference for an economy which spends more than it produces.
Getting back to our original premise, that of inflation or deflation, i.e. what is happening with the money supply?, we see that the "narrow money" M1 has been expanding steadily for the last 35 years at approximately a 700% increase. M3, (the category of the money supply that includes M1 plus M2 as well as all large time deposits, institutional money-market funds, short-term repurchase agreements, along with other larger liquid assets. This is the broadest measure of money; it is used by economists to estimate the entire supply of money within an economy) however, has been growing even faster which could be seen as intuitive since one must take into account extended fractional reserve banking and the growth of financial derivative instruments - this is corroborated in the chart showing growth of 1600% for M3.
So in fact, narrow money growth has been trailing broad money growth by a factor of roundabout 2:1. Does anybody still have any questions as to whether the quantity of "money" is growing? The final graph shows the "robust" US economy from 1947 to today. Even taking into account business cycles, there can be no disregarding that from 1975 onwards, the US become a slow net importer of goods and that from the dot.com mid 1990s it became a hyper-importer of goods from abroad, which coincides precisely with the steepening M1 and M3 curves in the charts at 1995 and a dropping-off-the-cliff for net exports. Consumption not inward investment and a re-tooling for global competitiveness was the key. The US is really no longer a global producer and manufacturer but rather is a voracious consumer. The Fed has no choice but to print money and has turned away from Volckeristic aggressive monetary policy of the late 1970s as likely to be too painful for the public, but more importantly, too dangerous to the intertwined imbalances currently reigning in the global marketplace.
In conclusion, if the wise and learned sages at the Federal Reserve have only soothing words and acrobatical statistics to offer us as regarding the state of the US economy, then please take it all in stride. Knowing when to fold and when to bluff is still an art which must be learned. Right now, I'd say the Fed is bluffing. I see inflation in their cards. Of course, we also know that too much inflation can end up causing very deflationary forces to take hold a la Weimar Republic in Germany. In that sense, both parties may be correct, but as with many things in life, the order of events is the key.
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This rather longer foray into the historical and macro backdrop of the Fed and whether we are headed for inflation or deflation was not really intended to be so long but once I got going I saw no reason to cut it short. The next Letter will look more closely at the markets and metals and some important issues on offshore investments. I hope to have an update on the weekend - see you soon.
Things have been a bit hectic on my side as I am getting ready to move offices and therefore my orderly chaos has now been replaced by complete chaos. I hope the next few weeks things will settle down again…
As quoted by the physicist Albert Einstein, who said, "Two things are necessary for our work: Untiring patience and the willingness to throw away work in which one has invested much time and effort."
timestamp : 19 Oct 05 17:25 CET / Berlin, Germany
Randolph Buss
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