Inflation Remains Beyond Our Horizon to Predict

How can we invest without knowing six months from now what inflation will be doing? We surely can trade, but long term investing involves exposure to economic storms and changing market conditions (aka “risk”). Is an accurate six month economic forecast too much to ask? Unfortunately, it is.

Poor Economic Predictions

For whatever reason we would like to postulate, the economic forecasts used by Wall Street have been well off of the mark. This week the Philadelphia Fed’s quarterly survey of Economic Forecasters said we are now in a recession which began 7 months ago while three months ago they predicted no recession and slow growth through the rest of 2008. Similar off-the-mark predictions have been made by the National Association for Business Economics, the President’s Council of Economic Advisors, and the Fed itself.  There is no evidence to support that any economic forecast of more than a few months is valid based on recent track records.

The Cause

I like the way the words “black swan event” sound. It was re-coined by Nassim Nicholas Taleb in his 2007 book The Black Swan. Taleb claims that almost all consequential events in history come from the unexpected - while humans convince themselves that these events are explainable in hindsight. This is one reason the economists almost without exception have recently had significant forecast errors. We are in a hundred year economic storm. This storm was not predicted, and its effects are obviously unpredictable.

Future Economic Predictions

Certain economic and market forecasters are saying all recessions travel similar paths, and the market will follow a predictable path to recovery. This is backed by a myriad of charts and formulas. They might be correct, but if the economy has not been following a predictable path  – how can we now assume that future forecasting will suddenly be accurate? There will be an end to this black swan event. The end will be when we are able to integrate the elements of this event into our charts and formulas and start to explain what has happened.

Our Economic Forecast Crystal Ball is Only a Few Months

As investors, we have several good tools for short term forecasting of up to a few months.

• For the general economy, we have the U.S. Weekly Leading Index (US WLI) published by Economic Cycle Research Institute (ECRI). The last publication is here.

• For inflation we have the U.S. Future Inflation Gauge (USFIG) published by ECRI. The last publication is here. In addition there are inflation forecasts for Canada, UK, France, Germany, Spain, Italy, Korea, and Japan.

Future Inflation Worries

Watching the liquidity flowing from the Fed has got to get a reasonable person thinking about inflation. My position is that until we get some movement in the money (velocity), inflation will not happen. The graphs below are from Monetary Trends released Monday by the Federal Reserve Bank of St. Louis. This velocity graph from Monday’s St. Louis Fed release should remove any short term worries about inflation:

For a fiat currency, I believe growth in M2 is also an indicator of potential inflationary pressure (it is M3 for a backed currency). The graphs below show percentage change year over year. You can see the growth rate appears to be within past norms.

I believe that the economy has a long road to travel before recovery can begin. I accept that I may be wrong, and if I am we will have significant money velocity issues due the liquidity being pumped into the system.

Adjusted Monetary Base is the sum of currency in circulation outside Federal Reserve Bands and the U.S. Treasury, deposits of depository financial institutions at Federal Reserve Banks, and an adjustment for the effects of changes in statutory reserve requirement on the quantity of base money held by depositories.

The Fed realizes what they are doing is potentially very inflationary – but it is a black swan event. They are acting without a script. They did not foresee this, and their reaction to it was along the lines of what they would have done in 1929 had they been there. There will be unintended consequences. As investors, we must continue to monitor short term indicators – and be prepared to seize new opportunities and/or vacate our current investment strategy.  I would not believe any long term economic forecasts.

Disclosure: none

Comments

[investor88:]

Good point about inflation being triggered only if money moves ie velocity picks up. Otherwise money supply alone may not trigger inflation, in fact we now have deflation in the face of massive money supply.

2008 Nov 19 08:09 AM

[Mark Best:]

There is not going to be inflation until Mr. Obama and Ms. Pelosi reintroduce Automatic Cost of Living Adjustment from the 70s.

2008 Nov 19 01:51 PM

[bbowen7:]

Buy TIPS.

2008 Nov 20 12:11 PM

[carey_jim:]

When Apollo fell in love with Cassandra he gave her the gift of prophecy but Cassandra refused to become his lover.

Thereupon, Apollo placed a curse on Cassandra's head so that no one would ever believe her prophecies.

The only future that is worth predicting is the future that we make for ourselves.

But we have little control over the behavior of other people. We can only watch what they do, very attentively, and draw whatever conclusions we can.

What is certain is that we can't get in bed with the powerful if we want to be able to predict (some of) the consequences of their actions.

And in this world below, we can't expect to be right all (most?) of the time either.

2008 Nov 20 12:55 PM

[suolucider:]

How anyone can say this current economic crisis could not be forecast/predicted is unbelievable. Even an economics 101 student understands he cannot continue borrowing and buying without paying back what is borrowed. And he cant obtain the money to pay back if he does not have a job that makes more than it takes to pay basic living expenses. Ours is not only a debt driven economy but also a tax supported economy. Continuous offshoring, corporate consolidation, merging, tax breaks for the wealthy and corporations, stagnant/rretreating wages, the cap on income earned and social security, the loss of our industrial base and the last 20 years excesses have destroyed that government revenue source. Our Feds know what they are doing? Did they really think that we would never have to pay borrowed money back, that with our nukes we can hold the world hostage to our debts.
Apparently they currently think that this supposedly increasing of 'liquidity' by the bail out is going to increase more borrowing when all its really doing is 'giving' no strings reserves to the very top of this ponzi fraud we call our banking system in order to protect a few from losing at the expense of the many. There is no increase in money velocity when the money being pumped into the banking system is being held to pay their way out of their bad investments or given as bonuses to the CEO's. All the economic theory's and models cannot take into account the massive fraud, corruption and theft that has been perpetuated on our current fiat system. The difference between a fiat system and a hard backed monetary system is that when the abuses start on the latter it immediately causes your deflation's, inflation's, recessions's and depression's which have historically occurred very rapidly when there was any tipping of the balance's. The very proud pointing to the 'stability' of our current system, which has really had only a short lifespan, has worked until now. Under our current system we have managed to slowly ease into whatever is coming over the last 30 years which seems to be the period that all of the checks and balances, which our system was based on, were removed.
You state that the feds are taking actions that they would have taken if they had been there in 1929. Well were we not under the gold standard then? Every 'expert' I read has a different outlook on whats coming and they are all seem to be grasping for answers or trying to steer a direction with their words. The only consensus is, it's new, it's probably bad and it going to be big. I have to agree, I would not believe any long term forecast's.

2008 Nov 21 03:32 PM