Trading the Inflation Myth

by: Michael Shulman

I was eating breakfast and decided to try CNBC again – and heard two pundits discussing inflation. I gave up CNBC a while ago. I am not interested in the political diatribes and other nonsense spewed forth in the name of ratings. I long for the days when they actually focused more on markets and companies.

So the two pundits, quoting people they have never actually read, were beating the table about inflation. It was coming; 'time to go to the monetary bomb shelters'. They applauded third world central bankers who were hiking interest rates because of inflation, forgetting or not knowing they are raising interest rates because asset valuations are overheating.

And that is what Bernanke is trying to do here – raise asset values. The U.S. has undergone massive deflation – 30% plus in housing, 40% plus in commercial real estate. And for many portfolios, 25% plus in stocks. Bernanke is also doing it with fairly nimble hands and feet. His purchase of bonds through what the public calls 'QE II' is providing a massive liquidity injection to asset markets. But this liquidity is not reaching consumers. Despite the moans of un-tutored pundits, it is consumers, and to a lesser extent businesses, that drive inflation.

According to classical economic theory, modernized by Milton Friedman, Inflation occurs when the money supply increases and faces a fixed or too slowly increasing supply of goods, services and labor. (Please, Dr. Friedman, forgive my over simplifications.) One hundred dollars facing one hundred oranges means the average price is a buck. A hundred and fifty dollars facing one hundred oranges means the average price will be $1.50. And so on. One hundred dollars for ten workers is ten bucks per worker. One hundred and fifty dollars means fifteen dollars per worker. And so on.

Government data shows the money supply really is not increasing (the data I like to use) for there is little velocity to money: It is not being lent by banks at any rate near historical norms. So, no consumer inflation. What Bernanke has done is provided liquidity to banks and related institutions to raise asset prices and to help them produce profits that will help them with those toxic assets no one seems to discuss any more-- without having it spill over into the consumer’s pocket book. A neat trick. Well executed, Dr. Ben.

The very same talking heads are also worried about the debasement of the dollar, an outcome of the Fed’s QE II and a corollary to inflation. Sorry, not happening. Five years from now the dollar will be stronger than the euro, the yen and the pound for the simple reason that the ECB, the Bank of Japan and the Bank of England are going to provide even more liquidity than the Fed is due to struggling economies, sky high debts and the need to keep their currencies in line with the dollar to protect exports. China, Brazil, Russia and other “emerging nations”, as well as Australia and New Zealand, will see their currencies rise. And they should rise based on their ability to produce trade surpluses through commodity sales. Or, in the case of China, by ignoring the most Basic WTO rules and doing whatever it takes to employ twenty million more migrant workers every year.

Bottom line: The people, including some governors at the Fed, are really talking politics, not sound economic theory. Friedman wrote in an era of fixed exchange rates and a gold standard. If you extrapolate from his theory and other monetarists, the path of the Fed – and other central bankers in the developed world – will be to support asset prices and to monetize government debt and promises that will create debt in tandem. This will keep their currencies in relative alignment and force the upward re-valuation of emerging currencies.

What does this mean for traders? Simple – with unemployment high, and Bernanke actually believing his legal mandate is to worry about inflation and unemployment, (and that is his mandate) there will be a QE III. That is, QE III either in name or under the radar. Some smart economists I follow do not believe liquidity can solve the problem of structural unemployment now facing the U.S. That is true. But liquidity will enable the banks to continue to write down a trillion dollars plus in toxic assets. This will take another four to seven years, and will also keep government interest payments down. This, in turn, is helping the Treasury through the economic restructuring that is taking place.

A QE III means it will be impossible for the bears to have their way in 2011. You cannot fight the Fed – take it from someone whose service, "Michael Shulman’s Short Side Trader", is now two thirds long as part of paired trades that, blissfully, are working. The success of these trades means the market is stable, this week’s sell-off notwithstanding. That stability is assuming a) the market stays even or goes up due to liquidity or b) the market stays even or goes up because the economy roars ahead, pulling along corporate profits.

What is the best way for a trader to play more liquidity, a stable or rising market that actually rewards winners and punishes losers? In my own portfolio, Apple (NASDAQ:AAPL). See my column on Apple, something I prepared before earnings – drop dead earnings – came out.

One last note – my regrets for having fallen silent the past three weeks. This was due to personal matters. One good thing about the moron monetarists -- that was rude but I love alliteration - on CNBC, they got me angry and back to the digital bully pulpit.

Thanks for listening.