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The U.S. Bureau of Economic Analysis (BEA) released data Friday on personal income and expenditures that all should pay attention to.

Personal income declined a massive $505.5 billion dollars for the month of January at the same time as consumption expenditures rose $18 billion, or 2.4%, on an annualized basis. Unemployment is high, people are earning less, and yet the cost of living continues to rise. The Federal Reserve should really pat itself on the back for inflating equities and bonds, distorting credit markets, and price fixing our way to prosperity. May we forbid the ills of falling prices, which lower costs in a time of declining income, only to push ourselves to the apparently impossible Keynesian state of stagflation.

January's losses to income more than wipe out the $353 billion dollar seasonal gains of December, yet the cost of expenditures and prices is compounding month to month with no relief. The expiring payroll tax cut's effects are soon to weigh in as well, further complicating the financial situation of American households against a backdrop of slowing economies around the globe.

What Is Stagflation?

Stagflation represents the unusual scenario of high unemployment with a high cost of living. In traditional Keynesian theory, high unemployment means low demand, which leads to falling prices. The prescription to the scenario then is to uplift demand, raise prices, thereby raising incomes as well, which creates the need for more employment. The trouble occurs when real demand is not uplifted, only inflationary demand rises or savings are taxed thin, and the unemployment situation remains. Adding insult to injury, the difficulty in purchasing goods and services continues to rise. This is made more true when whatever rise in income does occur, the gain is so deeply concentrated that the non-neutrality of money shows deep face in all places but aggregate income figures.

Keynesian theory's success in pushing forward crises and masking prosperity usually requires a savings base to tap down and a low level of debt to begin with. Neither of these cases represent the current scenario, and this is why Keynesian theory is particularly ineffective at even postponing the problems within the real economy at present.

This is not to say Keynesian extremists like Paul Krugman will not blame the continued failure to raise employment on the lack of stimulus. Krugman recently said we should seek out negative social spending if nothing else is available, and use our resources to wage war against fake alien attacks to restore prosperity in the near future. What Krugman has failed to address is why costs continue to rise if the Keynesian assessment of low demand is correct.

Don't Say the D-Word

While many economists do not like the most profane of all words (parental warning: deflation), I will go out on a limb and say the type of deflation they are trying to combat is a good thing we would rather retain. Falling prices do not lead to an economic spiral down with income and expenditures falling ad infinitum as Keynesians predict. In fact, falling prices encourage more demand after critical points are hit. In particular, crises are represented by falling factor prices (aka early-stage prices), while retail prices (aka late-stage prices) remain relatively buoyed. This means the profitability of investing constantly rises, with the input vs. output spread (see graph below) turning positive eventually and then growing, creating the incentives we would want to kick start the economy on correct footing. Therefore the economy does not spiral down infinitely and we do not need to pretend that crises can be wished away by inflating costs and eating away at our future.

The Most Important Graph You Will See

The cost of acquiring basic materials for business and production relative to the prices achieved at the point of consumer retail is well above the historical average. Business profitability is about as bad as it was just before the crash and a similar crash may not be so far away. As cost pressures rise on front side of the capital structure, business liquidation and economic deleveraging become ever more likely.

The graph below is the spread between the index of prices for acquiring raw materials less the index of consumer prices, both normalized to Jan. 1, 2000. A rise in values therefore indicates business profitability is shrinking, while a fall in values indicates the opposite.

Click to enlarge image.

After the crash, business profitability was deeply increasing, but has now been pushed down again after stimulus measures. This is the purest evidence that the government's actions are stalling the recovery, and preempting us for another crash.

What Say Markets?

High costs and high unemployment do not bode well for the economy in general but what is the inevitable impact on markets? If the natural affairs of a scenario of high unemployment are a massive fall in capital and raw material prices, an incline in cash balances and the value of the dollar, and weak equities then what should we see given Keynesian intervention driving stagflation?

Since the Fed is doing everything they can to keep people out of cash, by destroying yields and inflating prices, there has been a reaching for yield as normally risk averse people are forced into very risky assets like junk bonds (JNK) or (HYG), equities (SPY), and emerging markets (EEM) or (VWO). Just because the prices of these asset classes are performing well does not mean their traditional risk has eroded. In fact, since the economy is still weak, the risks in these markets are marginally higher, but nonetheless investors are flocking away from guaranteed losses in cash into whatever promises them some dream of subsistence. These dynamics are usually the drivers of a bubble, so despite everyone saying equity valuations are historically cheap, the real economy is historically bad and this does not bode well for real earnings or asset values.

We seem to be in a transitory -- a favorite word of the Fed I will now use against it -- phase of dollar strength, rising interest rates, and weak commodities. This may be early signals of the Fed and fiscal authorities falling behind the economic pressures weighing on real output. Despite massive government spending, and an $85 billion dollar a month net print from the Fed, the market's problems appear to not be masked enough. If this is true, we are either in for another market collapse soon that will force fiscal authorities and the Fed to up its game, or they could preempt this scenario by acting on the early warning signs. The fact of the matter is in either case strong action is on the horizon, so the major factor in profiting in these markets in the short run likely comes down to timing.

If you are investing for the long run, however, the situation is simpler as you know the dollar must return to its decline in the medium term, interest rates will be forced down again, and commodity prices will be boosted higher as further stimulus measures of higher magnitude eventually arise. The best longer-term bets in my mind then are to short the dollar and purchase commodities. I am going short the U.S. dollar vs. Australian dollars and Canadian dollars -- whose internal challenges and fundamentals I will discuss further in future articles -- and purchasing hard assets, precious metals being my favorite (GLD, UGL, SLV) on the long side and (GLL) and (DZZ) on the short side.

Source: Incomes Fall $505.5 Billion, Expenses Rise - Can You Say Stagflation?