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Inflation – From High to Higher

The following are slightly-modified extracts from recent commentary that appeared at The Speculative Investor web site.

The Long Wave

Increasing prices are not inflation and decreasing prices are not deflation. Inflation and deflation are terms that refer to changes in the total supply of money. Inflation is, purely and simply, an increase in the total supply of money. If that increase is greater than the growth in 'real economic output' (goods, services, tangible assets) then some prices will rise as a result of the inflation. Similarly, deflation is a decrease in the total supply of money and it usually results in falling prices. Falling prices are not, however, necessarily indicative of deflation. For example, asset prices in South East Asia collapsed during 1997 and 1998, a period of high inflation for that part of the world (the Tiger economies were rapidly expanding their money supplies at that time). Furthermore, rises in US consumer and producer prices during 1997-1999 were minimal, although changes in the money supply tell us that this was a period of rampant inflation.

Some of the confusion surrounding inflation and deflation probably stems from the fact that changes in the money supply affect different asset classes in different ways at different times. For example, the inflation of the 1970s brought about substantial rises in the prices of commodities and hard assets, whereas the inflation of the 1980s and 1990s boosted the aggregate demand for financial assets. In a fiat-money world it appears that major (secular) trends determine the focus of investment and thus how the excess money is used, with the inflation acting to reinforce whatever trend is in place. The secular trend may, in turn, be determined by the Long Wave cycle of Kondratieff (a 55-60 year cycle).

Long-term interest rates peaked around 1980 and then began a secular down-trend. This down-trend in rates can be considered as the deflationary cycle of the Long Wave, although deflation (in the true sense of the word) never actually occurred. What did occur was downward pressure on commodity prices, a phenomenon that is often confused with deflation. The 1998 peak in the bond market most likely represented the secular low for long-term interest rates and the beginning of the next UP- (inflationary) cycle.

Whether or not 1998 gave us the bottom in long-term interest rates is open to debate since we do not yet have any technical evidence that the secular trend has changed. However, the point we wish to make is that what may, in fact, be in the process of changing is not a shift from deflation to inflation (we already have inflation), but a change in the focus of investment from financial assets to tangible assets.

It really is different this time!

We prepared the following chart to show just how extraordinary the present situation actually is. The chart is the sum of the 12-month rate-of-change (ROC) of the DJFI (Dow Jones Futures Index - an index of commodity prices) and the 12-month ROC of M3 (the total supply of money). Adding the two ROCs together provides us with an overall picture of the pricing pressures currently in the system (the DJFI ROC) and the pricing pressures that are likely to appear in the future (the M3 ROC - more money 'now' means higher prices 'later'). Each green arrow on the chart indicates a point at which the Fed commenced a series of rate reductions, whereas each red arrow shows the starting point for a series of rate hikes. Normally you would expect that tightening cycles (the red arrows) would begin at high points on the chart (when the combination of present and future pricing pressures are near their peak) and easing cycles (the green arrows) would begin at low points.

Note that the current rate-reduction cycle not only began at a higher point than any previous rate-reduction cycle of the past 15 years, it also began at a higher point than any previous tightening cycle.

Based on the above chart the situation at the beginning of 1986 appears to offer the greatest similarity to the present. In late-1985/early-1986, a Fed-induced credit expansion and a sharp fall in the oil price combined to provide the liquidity injection that fueled a 'ramping-up' of stock prices. The 1985/1986 credit expansion also resulted in a weaker Dollar and, quite logically, in the best stock market performance coming from companies that benefited from a falling Dollar and higher inflation.

The differences between early 1986 and early 2001 are, however, quite pronounced. In particular, debt levels (both corporate and consumer) and valuations are now much higher and, although we anticipate further consolidation in the oil price over the next few months, a dramatic oil price decline appears to be out of the question. In fact, the aggressive re-liquefication embarked on by both Wall St and the Fed over the past 2 months severely limits the downside in energy prices. There is, therefore, a lot more risk in the financial markets today than there was in the mid-80s, a reality that probably explains why the Greenspan-led Fed has recently abandoned its traditionally gradualist approach. When in doubt, governments and their central banks have always opted to err on the side of inflation.

Does more money = more energy?

The chart below highlights a serious and growing problem. Capacity utilisation for utilities (combined electric and gas) has reached its highest level since the early 1970s, hitting an incredible 97% in December 2000. Lower interest rates and the recent acceleration in the pace of money supply growth will only magnify this problem. Until new capacity can be built and commissioned, the only way to avoid an energy crisis is via a reduction in demand. However, the Fed's current monetary policies will tend to increase aggregate demand. If the on-going re-liquefication of the financial system is successful in postponing a recession, then much higher energy prices and critical energy shortages are likely. Any governmental attempts to keep energy prices at artificially-low levels (for example, by imposing price caps) will only exacerbate the shortage (as per the present situation in California).

There was, by the way, one time when more money did directly result in more energy. In China, during the late 1940s, the inflation rate got so high that paper money became the cheapest form of fuel (it was more cost-effective to burn paper money than to burn coal).

Steve Saville
Hong Kong

5 February 2001

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