Don't cure the disease, just disguise the symptoms

One of the greatest governmental success stories of the past 50 years (success, here, means the achievement of a desired objective) has been to convince almost everyone that inflation is a rise in a basket of prices. This message has been so thoroughly ingrained that even those who understand that inflation is a monetary phenomenon think that printing money causes inflation. Printing money, or creating it via book entries (the usual practice these days), does not cause inflation, it is inflation. Inflation, in turn, causes some prices to rise. Which prices rise as a result of the inflation is determined by such things as the trade balance, currency exchange rates, mass psychology, the investment cycle and the Long Wave cycle. However, governments have done such a good job of marketing their definition of inflation that as long as the CPI stays fairly flat most of the world believes there is no inflation.

Having the CPI as the widely-accepted measure of inflation is a wonderful thing for those in power. Firstly, they are the ones who get to do the calculation and get to determine the method of calculation (and change the method if the outcome is not 'right'). Secondly, if changes in consumer prices represent the inflation rate then there will usually be an excuse (something to blame) for the inflation. OPEC has been a good excuse in the past and will be again in the future. If bad weather causes a rise in the prices of agricultural products then another excuse is available. It will generally be easy to find reasons for an increase in prices that prevents the finger from being pointed at the government, the central bank and/or the monetary system that promotes the unfettered expansion of credit.

Inflation - nothing to worry about?

Another $40B was added to the money supply during the latest week (par for the course these days). We find it incredible how little attention is paid in the mainstream financial press to the extraordinary expansion of credit that continues in the US. Furthermore, when the explosive growth in the supply of US dollars does get the occasional mention it is not in the context of an inflation problem. Rather, it is typically portrayed as the Fed doing the responsible thing by trying to avoid, or ameliorate, a recession. What is even more incredible is that inflation is not being seen as a serious threat even as many of the government-manipulated indicators of inflation have recently hit their highest levels in many years and are clearly trending higher. Here are some examples:

a) The Employment Cost Index for this year's first quarter showed that labour costs increased 4.1% over the past 12 months and increased at an annualised rate of 4.4% in Q1 (a rising trend).

b) The median CPI calculated by the Cleveland Fed (the calculation removes any outlying values (extreme changes up or down) in any given month to get a better feel for the underlying trend in consumer prices) averaged 4.1% (annualised) in February and March. This is the first time since January 1996 that the median CPI has been 4% or higher.

c) The Price Deflator in Friday's preliminary Q1 GDP release was 3.2%, one of the highest readings of the past several years (the Price Deflator is the measure of inflation that is deducted from the nominal GDP to determine the real (inflation-adjusted) GDP).

As long as the Fed is not worried about inflation (or is focusing its efforts on stimulating growth) and the mainstream press is not emphasising inflation worries, we will be very worried about inflation.

A message from the markets

While the Fed and most financial journalists remain blissfully unaware of, or irresponsibly unconcerned about, the powerful trend towards higher inflation, the financial markets are not. The equity market began discounting inflation last October/November, as illustrated by the following chart of the TSI Gold Stock Index (TGSI).

The gold price itself has not yet reacted to the inflationary trend, but gold stocks have been reacting. The gold stocks are not reacting to what is currently happening to the gold price, they are reacting to what is going to happen to the gold price. Other sectors that benefit from higher inflation, such as commodity-related stocks, cyclical stocks and oil stocks, have also done well over the past several months.

And, it is not just the equity market that has been busy discounting higher inflation. Long-term market interest rates have risen since the beginning of this year despite (actually, partly because of) the 200 basis points of Fed interest rates cuts so far this year. We wonder how high bond yields will need to move before they spark a general realisation that something has changed and that one US dollar is going to be worth a lot less in years to come.

A Golden Irony

There are many examples of people who, in desperately trying to achieve an objective, actually achieve the opposite of the desired result. China's political leaders have provided many wonderful examples of such ironic outcomes over the past few years as their attempts to demonstrate their power and gain respect have, instead, highlighted their weaknesses and undermined their credibility. Another good example of irony at work is provided by the gold mining industry and its representative - the World Gold Council (WGC).

The gold mining industry needs to wake up and realise that its product is money, it is not an industrial commodity. The more the miners and the WGC try to promote gold for its jewelry or industrial applications, the more harm they will do to the gold price. This is because by playing-up the non-monetary applications of gold they are potentially reducing its appeal as an investment. If they really want to increase the overall demand for gold they should talk about the great inflation that is underway in the US, the consequential vulnerability of the US Dollar, and how gold can provide an effective hedge against the inevitable loss of confidence in financial assets. If they can't or won't do that, the next best thing for them to do is nothing.

Steve Saville
Hong Kong

3 May 2001

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