Inflation And Yields: The Evolution Of Gibson's Paradox And The Revolution In Prices, Part III

by: John Overstreet

(Note: In this "Inflation and Yields" series, I am outlining the fundamental relationships between and within yield and price complexes. In Part I of this article, we noted that deflated commodity and producer prices have been highly correlated with equity yields since 1871, in much the same way that producer prices were correlated with bond yields under the gold standard, a phenomenon Keynes called Gibson's Paradox. What is the connection? Part II looked at Britain. Part III looks at commodities in America. Parts IV and V will break down consumer inflation and stocks.)

Gibson's Paradox in America, 1800-2010

In reality, high profits tend much more to raise the price of work than high wages....In raising the price of commodities the rise of wages operates in the same manner as simple interest does in the accumulation of debt. The rise of profit operates like compound interest. Our merchants and master-manufacturers complain much of the bad effects of high wages in raising the price, and thereby lessening the sale of their goods both at home and abroad. They say nothing concerning the bad effects of high profits. They are silent with regard to the pernicious effects of their own gains. They complain only of those of other people.

--Adam Smith

In America, things are going to get a bit trickier, because we are looking for a transition from nominal prices to deflated prices, and we have to look at both equity and bond yields. But, the benefit of this confusion is that the data has a lot more texture and gives us a clearer image of how prices and yields have evolved over the last three centuries.

I should point out that both the earnings and dividend yields produce similar results with respect to correlations with various price series, although industrial commodities appear to be more strongly correlated with the earnings yield, while agricultural commodities seem to be more strongly correlated with the dividend yield (for whatever reason).

I still tend to think of the dividend yield as the junior partner in the equity yield complex, so I will focus on the earnings yield.

But, first, let's pick up where we left off: commodities and bond yields.

Because there is no continuous series of bond yields for the early 19th century (I am using Homer and Sylla's splices of New England municipal bonds and federal bonds) and there is not much in the way of price data, I have lumped together the 1800-1870 years into one period.

As I mentioned before, I have also tacked on two more periods, 1914-1959, and 1960-2010, which appeared to mark distinct monetary or inflationary regimes in my previous analysis. If one wanted to use the beginning or the collapse of Bretton Woods as alternatives, I think that would be perfectly legitimate, but I tend to think one would ultimately come to conclusions very similar to the ones that will appear in this analysis.

Below are the correlations between nominal primary commodity prices and the long bond. In addition to commodity prices, there are a few other producer goods, and a handful of consumer food goods.

US correlation nominal commodities and food and bond yieldClick to enlarge

(For sources, please see Part I.)

This is just another picture of the breakdown of the classical interpretation of Gibson's Paradox. It was strongest up until the establishment of the Fed, and then it broke down, never to return.

Deflating these prices by CPI weakens the correlations from 1800-1913, but strengthens them from 1914-2010, except for consumer food goods.

US deflated prices vs long bond yieldClick to enlarge

So, there seems to be a transition from nominal to deflated prices, supposing that Gibson's Paradox still exists. Again, I argue that nominal prices under the gold standard were real prices, but to a certain extent we can relegate that question to semantics. The point is that, even confining ourselves to the bond yield, a Gibson effect appears to still be felt in commodities markets, if we adjust for the decay of the dollar by deflating prices by CPI.

As I argue, however, it is more likely that the Gibson Paradox, although not wrong in its original construction, was unavoidably imprecise. There were no long-term equity yield data for Tooke or Gibson or Keynes to look at, and even if there had been, it would probably have been correlated with bond yields.

But, if equity and bond yields have only been incidentally correlated with one another since the establishment of the Fed a century ago, then we should be able to observe whether prices conform more to one yield or another.

Moreover, I say that it was always chiefly a commodity phenomenon. And yet, there is only weak support for that argument in the British data (keeping in mind that we have very little certain equity yield data for that market prior to 1926).

If it is the case, however, that it is rather hard to distinguish between the strength of the Gibson effect in commodity, wholesale, or consumer prices prior to 1914, but that since 1914, commodity prices deflated by CPI are clearly subject to this effect, that implies that there has been a revolution in the price complex, and that that revolution has impacted consumer prices in a completely different way than it has commodity prices. I believe that I can mark this change and that it coincides rather nicely with the change I noted within the yield complex in previous articles.

Before we get to that, here are the correlations for the earnings yield and commodity, producer, and a few long-range consumer food prices.

First, nominal prices.

us correlation nominal vs earnings yieldClick to enlarge

The nominal correlations remain fairly strong until 1960, and much stronger than the bond yields.

And, here are the correlations for prices deflated by CPI.

US cprrelation deflated prices vs earnings yieldClick to enlarge
That the earnings yield should compare so favorably to both nominal and deflated commodity prices during the 1914-1959 period while the correlation between those prices and bond yields should so clearly break down seems a very strong indicator that Gibson's Paradox was always primarily a commodity and equity yield phenomenon.

It is clear that in the 1960-2010 period, the strongest correlations are between equity yields and deflated commodity prices.

And, that strongly suggests that, with respect to the primary commodities market, Gibson's Paradox was not a function of the monetary standard but is and always has been a function of the real economy.

Here is another look from the perspective of producer price indexes from the BLS alongside commodity prices from the Grilli-Yang Commodity Price Index (GYCPI). I have spliced together WPI and the GYCPI to form a rough-hewn long-range commodity price index. Price series that begin from 1900 are from Grilli-Yang, including the Manufacturing Unit Value index (MUV), a measure of G-5 manufactured export goods prices.

nominal PPI indices vs long bond correlations USClick to enlarge

correlations nominal producer and commodity prices vs earnings yieldClick to enlarge

Commodity & producer price indices deflated vs earnings yield US correlationsClick to enlarge

Some of these correlations, however, are a little misleading. They mask another change that has been underway within the goods complex since Bretton Woods.

But, let's approach that question from a slightly different angle. It's a little unorthodox perhaps, but I will run at the problem a couple of times to clarify my meaning.

In the meantime, let's sum things up a bit:

1. Nominal goods prices, especially producer prices, were almost universally correlated with bond yields from as far back as 1730, but in the twentieth century, this correlation collapsed.

2. Nominal commodity prices were correlated with the earnings yield from 1871-1959.

3. Deflated commodity prices have been highly correlated with equity yields since 1871.

4. Therefore, it seems more likely that the Gibson effect is primarily a relationship between commodity prices and equity yields.

And, that raises a few questions. Namely, why was there a transition from nominal to deflated prices? And, if nominal consumer prices were positively correlated with yields under the gold standard, what about now?

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.