Posted by Don Martin on Tue, May 14, 2013 @ 09:11 AM
Will full employment economy create massive inflation?
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When the economy returns to full employment, will that result in massive inflation?
I doubt it. Most of the unemployed people are those who, if they became employed, would only earn close to minimum wage. Since many of the so called hidden discouraged unemployed people are receiving lucrative tax free welfare benefits then they would be reluctant to give those benefits up and go to work. If they did work then their after-tax income would be no higher than it is now, so they could not increase their consumption. When people and businesses get bank loans and spend it on non-productive consumption then this is what causes inflation. If someone getting close to minimum wage in terms of the value of welfare benefits suddenly became employed at a similar amount of income then his need for basic survival expenses would mean that he couldn’t qualify for a loan and thus couldn’t participate in the creation of inflation.
A return to full employment would awaken the bond market vigilantes and the Fed and this would result in interest rates increasing, which would act to cool down an overheating economy. When interest rates go up people are forced to get a smaller than planned for loan and thus the inflation causing nature of new loans would be diminished.
The consumers who can create inflation by getting a loan are the skilled professionals who currently experience an unemployment rate in the 3.9% level (for college graduates), which is below the hypothetical full employment rate of “natural unemployment” of 4%.
The economy is already at full employment in terms of the type of labor force members who are untainted by either an extended adolescence living with their parents or welfare-queenism. The groups “married men” and “married women” have a 4.4% unemployment rate regardless of skill or education. Thus the main risk of inflation occurring would not be from a change in the unemployment rate (nominally at 7.5%), rather it would come from those now fully employed who increased their work hours or hourly rate. Once they are armed with higher income they would qualify for and get bigger bank loans and then spend the proceeds on consumption. Most people don’t want to go into excessive dent that is based on a temporary surge of income and bankers have rules to filter out people who don’t have long term track record of being at a new, higher level of income, so this type of reason for bank lending to increase is unlikely to occur.
I have written an article “Employment better than appears”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Apr 23, 2013 @ 02:25 PM
Will the governments of the major nations create massive inflation?
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Many financial experts have warned that over the next several years various governments will be unable to pull out of the global recession and will be forced to engage in significant amounts of spending for stimulus, resulting in a repeat of the inflation of the 1970’s.
I disagree because the inflation of the 1970’s was a special case of a Keynesian inflation creation machine system installed in the 1930’s that spun out of control in the 1970’s. That decade was the only peacetime decade in the U.S. with high inflation. The Keynesian inflation machine consisted of minimum food prices, restrictions on competition, restrictions on imports, mandatory unionization of jobs, etc. Today the economy operates 180 degrees differently with things like design shops in developed countries that pit one low wage country against another to find the optimal cost saving solution. Unions, except for public employee unions, are fading away. The use of the internet and globalization to cut costs continues to grow.
In the U.S. the main reason for huge federal budget deficit over the next 30 years is due to government paid medical care, particularly Medicare where beneficiaries pay only a third of the cost over their lifetime. Ultimately Congress will establish a two-tiered health system where affluent people are encouraged or forced to pay the full cost of Medicare or bypass the system and pay twice. This extra cost burden will act like a tax to reduce affluent consumers’ purchasing power thus reducing demand and dampening inflation. Perhaps the solution to medically caused government deficits will be an analogy to people who pay taxes for public schools and then pay again to send their kids to private schools in order to get the best results. It may be expensive but some people think it was worth it.
If the U.S. federal budget deficit can be fixed through growing out of the 2008 crash and through requiring affluent people to pay 100% of the cost of their medical care then the future for the U.S. federal deficit might be pretty good, especially compared to other nations. I expect the other major economic regions to be stuck in the erroneous pursuit of trying to use deficit spending to shore up a system that already has too much government spending. The result may be that other countries experience something similar to the Japanese Soft Depression or the depression experienced by southern Europe. I expect that as Japan tries to create inflation that they will see their currency’s value drop making their exports very cheap. When we import their low cost goods and services then that will keep our inflation rate low. The deflationary or disinflationary events in the rest of the world will be exported to the U.S helping to keep our inflation and interest rates low. Of course, U.S. interest rates are already very low so they will gradually go up to “normal” levels, but will still experience a lot of downward pressure because of external foreign deflationary forces and capital flight into the U.S.
The major global economic themes in the next few years will be a fading out of the commodities and gold bubbles of the past 13 years, a gear shift in China and Brazil to a more normal, lower rate of growth, an end to U.S. Quantitative Easing that leads to stimulus in EM countries and stock bubbles in the U.S. When stocks go down after the end of QE that will be disinflationary.
My concern is that investors may be tempted to overpay for alleged inflation insurance by buying stocks, commodities, real estate, gold, only to find that the insurance is both dubious and overpriced. The best investment policy may be to avoid being lured into a false theme of growing inflation, while assuming that deflationary panic threats are long past.
I have written an article “Should investors fear inflation?”
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Apr 17, 2013 @ 06:31 PM
Inflation unlikely to return despite a new characterization of the jobless data
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I have been writing that the jobless situation is much better than it looks so investors should prepare for the Federal Reserve to return interest rates to normal levels. However rates may not go up that much because of the low and stable rate of inflation. Yesterday’s CPI report showed a 12 month inflation rate of 1.5%. The long run “real” rate of Treasury interest over a century has been around 2%, so that implies a 3.5% intermediate term Treasury rate, assuming the economy is affected by other forces. The Barclays intermediate term Treasury index is 0.75%. The ten year Treasury is at 1.7%. However, there is another factor besides inflation that can affect the level of interest rates, which is that when an inflow of foreign funds comes into a country then the currency may go up or the interest rate may go down.
I expect that the other major regions such as China, Japan, Europe now have or will have problems so their citizens will export funds into the U.S., Canada, and Australia as a safe haven. Nothing has been fixed in the Eurozone and Japan’s new Quantitative Easing bond buying program may trigger a massive capital flight into the U.S. If enough investors pile onto Treasuries as a safe haven this may make it difficult for the Fed to raise interest rates because raising interest rates would make the dollar go up when it already is above its average value. Currently the “DXY” dollar index is trading at 83 points; it has traded in past ten years in a range between 72 and 88. It won’t take much in terms of additional foreign panics to push the dollar to the high end of its range.
During the prosperous high growth 1990’s interest rates were often at low levels despite a booming economy. This was partly because foreigners used the dollar and the U.S. as a safe haven and because crashes in Emerging Markets put a downward pressure on worldwide interest rates.
I have written an article “Is gold a hedge against inflation?”
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Mar 15, 2013 @ 05:07 PM
Will the improving economy make interest rates go up to the high levels of the 1970’s?
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When the economy improves and recovers from a recession then the jobless rate returns to normal and the Federal Reserve returns interest rates to normal, according to classic theory. For several years the Fed has made interest rates artificially low to cure the economy. The risk is that a sudden surprise healing of the labor market could be grounds for the Fed to raise rates. This would hurt stocks, long term bonds, real estate, and even commodities.
There are two main types of long term unemployed: young college graduates and poorly educated high school dropouts. The young college graduates are held back from employment opportunities because people close to retirement age are holding on their jobs and delaying retirement in order to save for retirement. Eventually the older generation will finally be able to retire or will be too old to work and the young college grads will finally get a break and become gainfully employed. When they do they will have lower than hoped for wages and lots of student loans which will constrain their ability to qualify for a loan. The granting of new loans by banks is a key transmission mechanism in terms of how inflation is created. In a world where everyone has too much debt to qualify for a loan then no one can borrow extra money and thus no one (except the government) can create inflation. Thus the coming healing of the labor market does not need to be inflationary and so the healing won’t necessarily result in massive increases in interest rates. However, since rates are very low then when employment returns to normal then interest rates would need to go up both in terms of the “invisible hand” of supply and demand and in terms of the Fed trying to fine tune the economy. It could take a decade from now before the young unemployed graduates get substantial pay raises and pay down debt to the point where they can begin to engage in aggressive debt-fueled consumption. That is so far in the future that it is not even on the horizon. Based on how survivors of the Great Depression behaved after the economy returned to normal, the survivors refrained from excessive debt use for a long time. A similar experience may occur with today’s young graduates.
The other sector of hard core unemployed are those at the bottom of society with the lowest skills and education. They are hurt by globalization taking away simple jobs that will never return. Even if they get a near minimum wage job they will not be able to qualify for a loan for substantial debts and thus not contribute to inflation.
The prime potential suspects of the future causes of debt-created inflation would be the upper-middle class professionals who are already happily employed and successful businesses. But these people and businesses are being careful with their money with exception that some affluent people may be overpaying for an owner-occupied house in an elite neighborhood. Thus I don’t see much chance that the coming labor revival will result in the inflation caused debt fueled boom of the 1970’s.
Measuring the impact of unemployment, in terms of measuring the depth of a recession, used to work better when life was simpler. However, in modern times if the people at the top can earn and spend enough to make up for the lost consumption that would have been done by low skilled workers then unemployment may not be that useful in terms of gauging the right level of interest rates. When the Fed wakes up to this then they will raise rates even if unemployment is too high by traditional metrics.
The employment-to-population level which is at 58.6%, nearly the lowest in 30 years, is partly low because some fortunate baby boomers can safely take early retirement, others may have health problems that force them out of the labor force. Imagine a scenario where 25% of the population did a better than expected job of retirement planning and was able to retire early (possibly due to lucrative government employee pensions) and the other 75% needed to keep working. Then the fortunate minority actions would lower the employment-to-population ratio.
If an investor wanted to trade bonds using this article they might speculate that eventually the Fed would panic and raise rates (making bond prices drop) and then the Fed would realize inflation wasn’t coming only to find out that higher rates had shocked the speculative part of the economy (the asset traders) into a recession. Thus a future Fed rate increase might not effect jobs and GNP, etc. that much, but it would really hurt asset prices such as real estate, stocks, and of course long term bonds. This might be the final catalyst that bears look for that would lead to a cleansing crash that in turn would produce a foundation for a new 17 year bull stock market cycle.
Investors should protect their 401k by investing conservatively, avoiding bubbly assets and avoiding an excessive amount of high duration long term bonds.
I have written an article “Does jobless rate improvement mean stocks will go up?”
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Mar 13, 2013 @ 02:04 PM
Will Gold Go Down When the Recession Ends?
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Gold’s price will go down as the economy improves. The economy is improving which lessens the need for governments to engage in massive debt fueled stimulus. This means there will be less perceived risk of inflation even though the stereotype of recovery from a recession implies a higher CPI. During a recessionary crisis some investors worry that governments will engage in reckless deficit spending financed by inflationary Central Bank money printing. This fear factor is so great that investors have overpaid for alleged inflation hedges such as Treasury inflation indexed bonds (TIP’s), gold, base metals, stocks. During the coming economic recovery I expect the CPI to go from the mid 1-2% range to the low to mid 2% range. One could assume this increase in inflation would result in gold’s price going up, however, what is baked into the current price of gold was the mistaken assumption of future hyperinflation which won’t occur. As investors realize this they will move towards revaluing gold near a $1,000 target, down from the current $1,588.
During the inflationary 1970’s stocks failed as inflation hedge. Commodities appeared to have done well but that was in part due to the money market yield nature of futures contracts “yield roll” and was not truly an inflation hedge. This occurs when futures contract buyers save on the cost of interest during a period of high rates, so this savings goes to the contract seller (the short position holder) in the form of higher prices. If interest rates had been zero during the 1970’s then commodity futures contracts would have not gone up as much. In addition commodities went up simply because of unpredictable crop failure and a structural change the political nature of OPEC and not because they were intrinsically a good inflation hedge.
Since 2008 Central Banks have increased their purchases of gold bullion and ETF’s have had massive increases in purchases of bullion. The more people bought it on speculation the higher the price went, creating a feedback loop that fooled investors.
Based on gold’s price stabilizing in the early 1980’s at $400 and then adjusting for CPI gold should be roughly $1,000. If one assumes the massive Federal Reserve money printing of recent years is inflationary then of course gold would need to be valued well over $1,000. However, the increase in the money supply is inside of commercial banks that can’t find qualified borrowers. The banks in turn park their excess funds at the Fed so the extra money has merely made a round turn back to where it came from instead of into the hands of consumers who would spend it and create inflation. The extra borrowing by the Federal government and the extra money printing by the Fed merely acted to prevent a depression/deflation and didn’t create inflation.
China bought a huge amount of commodities in the past decade which made some Western investors think that commodities were going up and that they should be used as a hedge against inflation. If China decides that they have overbuilt real estate then they will sell their surplus hoard of commodities, making the price go down.
As Central Banks throughout the world try to devalue against each other and to sell off gold this will create a demand for the dollar. This foreign devaluation will make foreign stock markets go up only to see that in dollar adjusted terms the share prices didn’t really go up. Expect some risk that high quality foreign currencies could weaken against the dollar, although the truly high quality foreign currencies will probably go up along with dollar against the value of the Euro, Pound, and Yen, which could lead China to keep the price of the Renminbei in line with the major competing currencies.
I have written articles “How low will gold go?” and “Gold going down”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Feb 27, 2013 @ 01:32 PM
Will the Unemployment Problem Suddenly Be Fixed?
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The Federal Reserve’s Quantitative Easing has exported inflation and growth to Emerging Market countries like China where wage increases drove out employers to places like Mexico. Now there are far less Mexicans coming to the U.S. because better opportunities are available at home. The result will be rising wages and employment in the U.S. for those willing to work in minimum wage jobs. On 2-19-2013 the Wall Street Journal had article about the new farm labor shortage.
In Brazil and Argentina a huge inflow of foreign capital has occurred because foreigners want to get the high yields offered in the Emerging Markets countries. This is making the EM countries experience a huge boom. For example Thailand’s economy grew 17% in 2012. Unfortunately when a boom occurs that could trigger inflation. Since the world economy is integrated then in some cases foreign inflation can leak back into the U.S. In China the workforce is becoming more expensive so employers are moving factories to less costly locations, including Mexico, which further drives up wages in the aggregate in the North American (NAFTA) area.
The worst part of the U.S. unemployment problem is in the lowest skilled occupations. If the sequester nudges the government to tighten welfare benefits, thus prodding some people on the margin to seek minimum wage work, this could lower the unemployment rate. Low interest rates correlate with high unemployment; as employment improves then interest rates will go up and bond prices will go down.
The slow rate of recovery for unemployment, if one counts the hidden unemployed, implies that it will take a decade from now or at least a decade from the start of recession in 2008 to return to a full employment economy. This is the main reason why interest rates have remained so low for so long. The risk to investors is that they assume interest rates and corporate expenses will stay low, thus justifying high and rising stock prices and real estate prices. If unemployment suddenly improves this could shock the economy into a sudden increase in interest rates which would hurt stocks, real estate, and hurt corporate profits as well as obviously hurting bonds.
Other reasons why the lower skilled people will get jobs is because of growing local domestic energy production which nurtures blue collar jobs in heavy industry (we will be the only large developed country with plenty of domestic energy); growing defense spending which requires work be done only domestically. The ACA health care law will provoke some employers to try incorrectly to avoid paying for health care by structuring work duties as an independent contractor and this will trigger more intense IRS audits resulting in more people being put onto payrolls who are currently working as a contractor.
This article is intended to look at hidden risks of a sudden inflationary increase in jobs. However the dominant probability is that so called "on-shoring" or domestic manufacturing renaissance will not add that many jobs, the welfare state won't change, and the intractably unemployed may remain stuck where they are. Further, many people are stuck in a self-made debtor's prison (metaphorically) of excessive debts so they can't resume the consumption rates of previous eras even if fully employed.
I have written an article “Fed’s Manipulation to Backfire”.
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Dec 21, 2012 @ 01:44 PM
What if inflation snuck in quickly – how would the economy react?
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The Wall Street Journal ran an article today saying two things could cause the Fed to raise interest rates sooner than expected:
One is the return of inflation and the other is the return of a full employment economy. The risk of a sudden reduction in the unemployment rate is greater than the risk of inflation according to the article.
My thought is that increasing employment is what facilitates inflation, so I can accept the premise of the article. Inflation is caused by banks increasing the money supply by increasing loan balances through the fractional reserve banking system. This is tied to rising incomes where people use their new employment income to qualify for and get a loan. (Not all loans are inflationary. If a saver gave up the chance to spend and lent the money to a consumer then there is no increase in the money supply. If a bond buyer gives up his cash to buy a newly issued corporate bond then the money supply didn’t increase, instead people were simply trading places with their liquid assets).
How might full employment return faster than expected? If the Emerging Markets keep growing they will need to get skilled workers from the U.S., which would lower our rate of unemployment. Also the EM countries are experiencing inflation and may find in some cases, adjusting for quality and consumer protection, that it is actually quite affordable to buy things in the U.S. So there is a risk that the bearish deflationary paradigm could come to an end faster than expected.
Ironically a sudden increase in economic activity that would justify having the Fed raise interest rates would actually be bearish because when rates rise to normal levels this affects the “discount rate” used to calculate the value of stocks. A low and dropping interest rate is giant lever that makes stocks go up; high and rising interest rates acts in the opposite direction, making stocks go down. A similar thing will happen in real estate: rising rates hurt real estate. If a full employment economy suddenly happened that would mean more people could buy with a new job but they would have to buy a lot smaller house because if the interest rate doubled that would greatly reduce their borrowing capacity.
I have written an article “Shocked by low rates? Expect more shocks”.
Investors should seek independent financial advice.
Posted by Don Martin on Wed, Oct 24, 2012 @ 09:17 AM
Can junk bonds (high yield bonds) be used as a hedge against inflation? A popular myth is that if inflation returns then junk bond issuers (borrowers) will have an easy time repaying their debt and this will make them less risky using them to improve their credit quality, which in turn would make the bonds go up in value.
The problem is that junk bonds are junky for a reason. It is not simply because they forgot to mail a check on time for a petty minimum payment on their credit card, thus damaging their credit score. Rather the reason junk companies are rated as junk is because their earnings capacity in proportion to their debt is poor. If they suddenly find that repaying the debt back with cheaper dollars during inflation is easier they still need to earn a living by selling goods to the public. If the public is hurt by inflation then consumers may reduce purchases, and society will become poorer as a result. Thus financially weak companies (junk bond type of companies) could find they are even more risky during a period of inflation. Then the rating agencies could further downgrade them. If inflation comes back many loan contracts are adjustable rate and would quickly go up to compensate for inflation, thus hurting borrowers. A junk borrower might only be able to qualify for an adjustable rate loan with no caps. So during inflation a junk rated borrower could get even riskier. A junk bond borrower may have a significant portion of debt in the form of bank loans that are usually short term adjustable rate and are senior to the position of bonds. The bond might be a fixed rate of interest. So rising rates could kill a junk bond issuer. When they file bankruptcy, then during the two year wait to get out of bankruptcy, no interest is allowed to accrue. If you were counting on getting big coupons and got nothing for two years then you would certainly not get compensated for inflation.
One key reason that a junk corporation is rated junk is because they suffer from an inability to develop a commanding presence in their market and instead struggle to compete against stronger companies. This won’t change if inflation increases; it will actually worsen if inflation increases.
Payment for groceries during inflation?
During the great inflation of the 1970’s stocks did not provide a shelter from inflation. The nominal price went down and then recovered but on a “real” price it went down and stayed down. Since junk bonds are similar to stocks (they go down when stocks go down) except they don’t provide the upside potential then a repeat of the 1970’s implies that junk bonds would not do that well. A repeat of 1970’s inflation would be different because lenders, vendors, pension beneficiaries, and unions learned to protect themselves by having COLA adjustments in contracts, so inflation will help almost no one and that includes junk bond issuers. Also rising interest rates would hurt the value fo junk bond just as it hurts investment grade bonds.
Since contrarian investing is the key to investment success then a contrarian strategy regarding inflation is to hold two year investment grade Treasury Notes and roll them over into new higher yielding Notes as inflation increases. This strategy or else owning cash were the best strategies to deal with 1970’s inflation. Of course the Fed could decide to make interest rates artificially low during a time of high and rising inflation, but they usually don’t.
Even the best investors can get burnt by junk bonds. I wrote an article “Berkshire losses 48% on junk bonds”.
Investors should seek independent financial advice.
Posted by Don Martin on Tue, Oct 16, 2012 @ 10:29 AM
What is the fair value of gold and how will it react to inflation?
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For centuries people have used gold as a store of value. It could be considered a form of money since money is a medium of exchange. If someone is stuck in a country with hyperinflation and no right to convert his currency to a foreign currency then they may find owning gold makes sense. But what if the inflation rate is 2% and some fear it could go up to 10% because of all the Federal Reserve’s money printing?
The best estimate is to look at the traumatic inflation of the 1970’s which was the worst period of inflation in the U.S. and the only significant period of peacetime inflation. For 1965 when the U.S. withdrew all the paper money that had the phrase “silver certificate” on it and withdrew all of the silver coins inflation went up rising to 14% in some years until 1981 when finally extreme tightening by the Federal Reserve brought inflation to normal level. During that time consumer prices increases by several hundred percent. Gold went from $35 to roughly $400 and then settled near $400 for nearly 20 years from the early 1980’s until 1999 when it went down. I think it is fair to say that once gold leveled off at $400 in the 1980’s that it was fairly priced then. So using that as a benchmark and applying a 300% increase in the CPI since the early 1980’s implies gold is worth $1,200.
During a period of panic people will overpay for a well known, high quality asset by 50% to 100% beyond fair value. (For a flaky asset like new dotcom stocks they may overpay by a factor of 10 or even 100). So gold could be the object of panicky investors overpaying by 50% to 100% beyond a fair value of $1,200. Thus it could briefly spike to $1,800 or $2,400 and then come down to $1,200 and go even lower as the pendulum swings too far in the opposite direction. During January, 1980 gold briefly reached $880 and then gradually went to $400 as panicky conditions changed to favorable conditions. So it demonstrated an ability to go to 100% of fair value and then return to settle at fair value for two decades.
My concern is that gold investors and TIP’s investors are trying too hard to protect from the risk of serious double digit inflation and are overpaying for protection, just like in the Cold War the U.S. overpaid for military defense against a crumbling Soviet empire.
Inflation if it comes will come from prosperous businesses and consumers borrowing too much and spending the newly created money. This happened in the 1970’s. But weak consumers can’t qualify for a loan and need to pay down debt. Strong corporations don’t need to borrow and banks only lend to creditworthy business borrowers with a documented, wise business plan showing how the business will use the money. So the banks won’t create inflation. Congress could, in several decades, continue to grow the deficit and then order the Federal Reserve to monetize the Federal debt, but that is unlikely if voters put pressure on Congress to avoid extreme deficits.
I doubt that extreme inflation will occur in the next decade, especially with the problems in the Eurozone, Japan and the high unemployment in the U.S. that we have been stuck with for four years with no end in sight.
A better hedge against inflation might be a basket of short term bond where one could roll them over into new, higher yielding notes when they come due. Assuming a repeat of the 1970’s then by buying a new two year note with a new higher coupon to compensate for inflation one could still get a modest real return; by contrast stocks did not go up enough to compensate for inflation in the 1970’s.
I wrote an article “Is gold fairly priced?”
Investors should seek independent financial advice.
Posted by Don Martin on Fri, Sep 14, 2012 @ 02:25 PM
Fed’s QEi or QE∞ and its effect on the market
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Regarding the Fed’s decision yesterday to provide infinite purchases of bonds, this was designed to lower the rate for bonds but the ten year Treasury yield shot up from 1.72% yesterday morning before the announcement to 1.86% today.
The big picture way of viewing this is to recognize that “real” long term Treasury rates have averaged 2%. During recessions people need to accept a lower real rate as the price to pay to get a safe haven. So the current long term Treasury rates are not that unreasonable, as long the economy stays weak. Long term Treasury rates for Germany and Japan are lower.
The history of the U.S. before the Keynesian myth was established in the Great Depression of the 1930’s was that there were many depressions (caused by collapsed investment bubbles) that often lasted 15 to 22 years. The U.S. experienced extreme good fortune in WWII and as a result it was sheltered from foreign competition for 25 years from 1945-1970 creating a myth of a permanent plateau of prosperity created by Fed monetary and Congressional fiscal policy. This made people think deflation risk had been permanently engineered away and should be viewed as an impossibility. People became accustomed like Pavlov’s dogs to assume that all recessions are magically cured and turn into V shaped recoveries in a year or two thanks to government intervention. Also people are unduly influenced by the 1970’s era of severe inflation into viewing that as a far more likely risk than deflation. However the only peacetime inflation era in 220 years was the 1970’s. My point is that both investors and financial professionals are brainwashed to assume that deflation and depression are an impossible phenomenon and that the risk of a repeat of 1970’s inflation is highly possible. Please keep your mind open to new ideas.
The depression-free post-war era was an outlier that won’t happen again
The history of 1945-1973 was a statistical outlier of unusually good macro conditions that created a long term boom. The history of the Greenspan or Bernanke Fed since 1987 was one of continued attempts to stimulate the market with undeserved bailouts of irresponsible overleveraged companies such as the massive bailout in 1998 of a hedge fund or the funding of a non-recourse loan to the 2008 bailout of gigantic financial companies. The good stock market results are not the same as good results in the real world economy. People may be tempted to think the Greenspan or Bernanke Fed 1987-2012 stock boom is assign of economic health that is a continuation of the same prosperity of the post WWII 25 year era, but it is not. The prosperity of 1945-73 was based on a solidly growing GNP which was legitimately reflected by a rising stock market; by contrast, the Greenspan or Bernanke Fed 1987-2012 era was one of excessive stock price increases and excessive bailouts so stocks did not reflect the true value of the real economy.
So the myth of Keynesian economic management and bailouts has been perpetuated by the post-war prosperity where our trading partners had to rebuild from nothing; after 1987 it degenerated into an era where people hurt by loss of jobs due to globalization turned to speculation and debt fueled consumption rather than generating income from fundamentally solid economic activity. The point is that some of the prosperity of 1945 to present needs to be seen as either a smokescreen caused by speculation or by a one-time post-war lucky break. Thus one should consider the possibility that the pre-1930’s era of repeated bubble crashes and long depressions is relatively normal and the possibility of a repeat of the full-employment inflationary 1970’s is actually smaller.
What makes the U.S different from most countries is that banks are tightly regulated and can only loan to creditworthy borrowers using the income method of lending. The banks managed to trick the regulators to be fooled by the ridiculous concept of “Easy Qualifier” mortgage lending which didn’t use income analysis, which explains why the housing and mortgage bubble occurred. Except for the aberration of the era of poorly underwritten mortgages, bank lending in this country has always been a strict process that required good income to qualify. There may have been junk bond issuance by high risk corporate borrowers where they lacked sufficient income but that was not a bank loan.
The U.S. history of tight bank lending means is that it is very hard to transmit inflation out of the banking system.
Inflation is caused by an increase in the money supply. It is like trying to get a mosquito to transmit malaria to Eskimos living in igloos. The environment doesn’t facilitate the transmission of the disease. With a financial ice age upon us inflationary mosquitos can’t breed and spread inflation. Other nations often have regulators pressure banks to lend inappropriately to an industry that is deemed to be in the national interest to obtain financing. Thus other countries have a greater chance of spreading inflation through their banking system.
The Fed will purchase mortgages from wealthy people and pension funds. These sellers will have cash to spend. It will be reinvested somewhere and will not be spent at Walmart buying groceries, so it won’t cause inflation. Meanwhile a moderate income retiree living on interest income will have to cut back on their consumption, so the net effect of low rates may be less consumption not more. As investors flee the U.S. by investing in Emerging Markets stocks and bonds in hopes of getting higher yields this creates growth in those countries which may remove some growth in our country. This results in a deflationary financial vacuum in our country. When an investor with too much money gets careless and overpays for stocks, creating a bubble, then eventually the bubble bursts which is the opposite of what the Fed intended.
The Fed will offer a huge pile of cash to lower interest rates
Lower interest rates don’t help the economy because only well qualified people or businesses can get a loan (or issue a bond) and they don’t see sufficient business opportunities to justify a debt fueled expansion. The Fed’s medicine is a placebo. The only way for the government to stimulate the economy is with Congressionally authorized fiscal policy and this will continue to be blocked by conservative legislators who fear big deficits. The greatest risk in the intermediate to long term is the massive Federal deficit so I expect continued growth in the numbers of voters and Congress members who oppose increased deficit spending. That is a huge deflationary risk.
The Fed stimulus can only help by creating a stock bubble and then there will be a tiny trickle-down effect as the rich buy a few more luxuries.
Japan has been stuck in a deflationary trap for 22 years which continues to amaze me for each year that it continues to be trapped.
The stimulus that got the U.S. out of the Great Depression and which will work this time is not the Fed monetary policy, it was the action of workers cutting their wages which made possible more purchases when goods could be sold at lower price levels. Today conditions are being set for a repeat of that. First the U.S. has huge amounts cheap natural gas and coal that are located near factories. No other developed country except Canada and Australia have this. Secondly we have a healthier banking system than the Japanese and Europeans. Thirdly we have a situation where people who have spent years trying to recuperate from the crash will finally get motivated to get out of debt through bankruptcy or foreclosure and move to a new town where there is lots of employment and start over in a new career with a low wage and low debt servicing costs. The combination of hard work, declining wages and cheap natural gas will enable the U.S. gradually take business away from other developed countries and return to full employment, but it will take a long time.
Typically bear stock markets last 17 years. The current one started in 2000 so perhaps in 2017 things will turn around. That would definitely be the latest that one could be a bond bull before it is time to reverse positions 180 degrees. However as interest rates get progressively lower the fear factor (fear that bond yields are simply too low and that inflation will strike) can make bond prices more volatile. So even if the ten year Treasury yield is fated to go down to 1.0% or 1.25% in the next year or two it will be accompanied by a higher degree of risk of temporary panic sales. Thus investors may wish to consider reducing risk in bonds by reducing maturities.
I trust the bond market professionals to be objective while participants in other markets such as commodities, stocks, real estate may act emotional, unprofessional and chase after bubbles. Today bond yields didn’t go up that much despite the infinite nature of yesterday’s QEi. Are the bond market vigilantes saying that the Fed won’t cause inflation?
There is a new era that began last week with the ECB’s Mario Draghi announcing a more determined stance to loan money to bailout failed Eurozone countries, and the September 12 German court decision allowing bailouts and yesterday’s “infinitive” QE announcement by Bernanke. The challenge they face is that it will take more than merely lowering interest rates (which has not worked) to cure the economy. Thus the new era of more loose, aggressive monetary policy by Bernanke and Draghi will not be enough to cause inflation in the U.S. but it will in Europe due to an expected devaluation of the Euro. Ironically the Euro ECB bailout by weakening the Euro will make capital flee into the Treasury bond market so this will further reduce the chances of the Fed to inflate its way out of the recession.
The core crude intermediate PPI, which is a good indicator of future CPI, is down 1.6% in the past 12 months.
I wrote an article “Fed’s QEi announcement” and “QE2 won’t work and will damage the Fed” and
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