Thoughts on Inflation, or is that Deflation?

You can't read a newspaper article without reading comparisons to a past financial crisis. The conclusions will vary depending upon which time period is used for the comparison. I though it was useful to run through the similarities and differences between this and past crises. The following table outlines the comparison between the current period and three prior periods: the Great Depression, the Stagflation of the 1970s, and a recent but mild recession in 1992. I look at various key stats, particularly as they relate to the current hot button issue: are we headed for higher inflation?

Great Depression (1929-40)
Stagflation (1972-83)
Gulf War (1990-93)
Real Estate Bust (2007-?)
General Price Direction:
-Great Depression - Deflation (-25% or -7% per year through 1933)
-Stagflation - Inflation (+140% or +8-9% per year)
-Gulf War - Disinflation (+10%, or +3-4% per year)
-Real Estate Bust - ?

Fed Funds Rate:
-Great Depression - Raised
-Stagflation - Lowered
-Gulf War - Lowered
-Real Estate Bust - Lowered

Note: The Fed lowered rates in '72-73 to fight recession, raised them sharply in 1980 to end inflation. The Gov't printed money in 1941 to finance war, which reinflated economy, after maintaining tight monetary policy throughout the Depression.

Unemployment Peak:
-Great Depression - 25% (1933)
-Stagflation - 10% (1982)
-Gulf War - 7.5% (1992)
-Real Estate Bust - 5% (Current)

Began with a Debt Crisis?
-Great Depression - Yes
-Stagflation - No
-Gulf War - Yes
-Real Estate Bust - Yes

Note: Interest rate hikes in 1980 to end inflation were the primary cause of S&L crisis during that decade, helped along by Congress in 1982.

Commodity Prices:
-Great Depression - Flat (after brief drop early)
-Stagflation - Up (+350% to 1982 peak)
-Gulf War - Flat/Slight decline
-Real Estate Bust - Up (+300% since 2002)

Real Estate Prices:
-Great Depression - Down
-Stagflation - Up
-Gulf War - Mixed - declines in certain markets
-Real Estate Bust - Down, severely in some markets (after bubble)

Currency Rates:
-Great Depression - Fluctuated (+0% vs GBP)
-Stagflation - Down (-43% vs DM)
-Gulf War - Flat (+2% vs DM)
-Real Estate Bust - Down (-40% vs Euro since 2002)

Stock Market:
-Great Depression - Down (-70% to 1933, -42% to 1940); bottom P/E: 8x
-Stagflation - Down (-37% to 1974, +50% to 1983); bottom P/E: 8x
-Gulf War - Up (+50%); P/E: 15-20x
-Real Estate Bust - Down (-15% to trough so far)

Peak-to-Trough EPS Growth:
-Great Depression: -27% (to 1933)
-Stagflation: +21% (to 1974)

Geopolitical:
-Great Depression: Turmoil and war in Europe and Asia
-Stagflation: Middle East, Vietnam, Cold War
-Gulf War: Middle East, End of Cold War
-Real Estate Bust: Middle East, Terrorism

Demographic/Technological Changes:
-Great Depression: Urbanization, Mass Production, Improved Farming
-Stagflation: Baby boom, robotics
-Gulf War: Computers, free trade
-Real Estate Bust: Rise of China/India, aging boomers

Identified Causes:
-Great Depression - Credit collapse, rising interest rates in the face of deflationary shocks, severe restrictions on international trade, European collapse, demographic/technology changes, tax hikes, severe drought
-Stagflation - Low interest rates in the face of rising inflation, de-linking of fixed currency unleashing pent-up inflationary pressures, tax hikes, technological change, demographic changes
-Gulf War - Credit crisis
-Real Estate Bust - Credit crisis, real estate bubble collapse, demographic change

The only similarity between the 1970ss and today is the surge in commodity prices and the decline in the dollar. However, these events occurred several years prior to the current crisis (since 2002), while in the '70s commodities surged while stocks declined and inflation heated up simultaneously. Commodities stayed flat during the Great Depression after a brief plunge early which reversed itself. Therefore, commodity prices do not appear to be a good indicator of recession or inflation, as they have behaved very differently in every period studied.

As you can see, the current crisis has both similarities and differences to each of the other three periods. The media likes to compare 2008 with 1973 because of the commodity price surge and the fact that the stock market has not returned anything in either decade (1972-1980 versus 2000-2008). However, the comparison falls short because we are currently experiencing falling asset prices (excluding commodities) and a debt crisis, neither of which existed to comparable severity in the 1970s and both of which are highly deflationary. In addition, the stock market experienced a deflationary collapse in 2000-2002 of a magnitude not seen since the Depression, yet only resulted in a modest recession and no inflation.

The lesson here is that every period is different, and making comparisons could lead to wrong conclusions. It is therefore important to understand the underlying causes for each of the phenomenon. Commodity price surges in the 1970s were primarily the result of monetary expansion and inflation, and were not a cause of inflation. Thus, the run-up occurred subsequent or simultaneous to recession and inflation. From 2000-2007 there was significant demand pressure on commodity prices driven by various external factors, mostly China and India, and has since led to investor speculation leveraged by significant use of derivatives

ol (up to 20:1 leverage) in the last couple of years. As the US dips into recession, the rest of the world will follow, and demand for commodities will fall (as has already begun). Ironically, supply is still declining in certain important commodities as well, attributable mostly to political factors. Further, high prices will finance the hunt for alternatives, as is also in full swing.

What about gold? Gold is difficult to analyze fundamentally, because it has little value aside from its use as an informal currency (even jewelry demand is an indirect function of its status as a symbol of wealth). If gold is again adopted as a quasi-formal currency, then it would be valued the same way paper currency is - supply and demand. Ironically, however, a bid up in price of gold is likely to a self-defeating prophesy in this regard.

So what is driving investors to commodities? Commodity prices go up every time interest rates go down, all else equal. This didn't happen in the 1990's because of excess capacity and productivity improvements. So, yes, commodities are indirectly linked to inflation since low interest rates sometimes fuel inflation absent other deflationary factors.

Why are commodities linked to interest rates? Because when interest rates are low, the cost of owning real assets is low. When rates are low, investors have little incentives to own interest-bearing securities, because the risk of rate rises - and even inflation - outweighs the return expectation. In times when investors have an appetite for risk, they move into stocks (like the growth stocks of the late 1990's). When financial leverage is available, investors use it (with the low rates) to buy real assets, as in real estate, LBO's (aka private equity), and M&A. When the price of risk is high and/or when debt is not available, commodities become one place to invest. Of course, leverage can be obtained with commodities through derivatives.

The mistake the Fed made in 1973 was to lower interest rates in the face of commodity price shocks (mostly oil) when no deflationary factor was present, which of course aggravated the problem. It was believed at the time that commodity price shocks would be deflationary (by shifting capital away from the rest of the economy) - that turns out not to be true. The Fed made the opposite mistake in 1929 by removing liquidity from the financial system when very severe deflationary factors were present (they did it again in 1936-7), aggravating the problem. At present, if the Fed cuts rates further (more than the market already expects), then the likelihood is for further commodity price gains. However, when the Fed raises rates again in the future, which it most certainly will, there is a good chance that the bottom will fall out on commodities, as it usually does in these kinds of circumstances.The recent commodity price moves are simply not explained by underlying industrial demand or inflationary factors, in my opinion.

Inflation is simply a monetary phenomenon - the supply of currency relative to demand. However, supply is complicated by multiplying factors, otherwise known as leverage or debt. The base money supply is magnified by up to 10:1 by lending, and probably additionally by other leveraged factors such as derivatives, then recycled again for more leverage. Growth in base capital has multiplicative effects on the growth in aggregate money supply (sometimes informally known as "M4") as well as on growth in money demand. But when a credit crisis hits, lenders are forced to stop lending to rebuild their capital base, which has a similar multiplicative effect in reverse. This can cause deflation and recession. This is what the Fed is most concerned about right now.

What is the risk of inflation? In my opinion, the primary risk is that the Fed will overshoot. Greenspan is now being criticized for overshooting in 2002 and fueling the real estate bubble. Indeed, spontaneous asset bubbles are a very clear risk of low interest rates, even in the face of modest inflation, and especially since we have experienced a global savings glut. By the way, I believe that the net debt statistics on the US citizens tends to be overstated because the assets of US citizens are understated. The same is true for the current account deficit, which appears to understate US exports.

Fellow ID Thomas Tan's arguments about Gold are interesting, specifically his discussion of emerging market citizens' understandable aversion to fiat currency. While I don't agree with some of his macroeconomic arguments, if his analysis of gold demand is correct, then emerging market demand for gold will continue to grow. What I am interested to know is the degree with which derivative leverage has magnified the demand impact on gold specifically, and how fragile that leverage is - could a small correction be magnified into a general price implosion? If that leverage is significant, then any fluctuations in base capital would overwhelm any emerging market core demand effects.

In general, I believe the inflationary pressures we are seeing now are a function of a speculative bubble in commodities, magnified by derivative leverage. I don't believe that the price levels in commodities (or currencies) are sustainable long-term, unless the Fed gets reckless with monetary policy. The key risk to the Fed is when the financial system starts to reinflate and restarts the lending process, which will cause the end-market money supply is likely to expand rapidly. Once that happens, the Fed will need to reign in liquidity - if it moves too fast then it may nip it in the bud, but if it moves too slowly then it could fuel another asset bubble or ignite inflation. Further, it will need to tread carefully the resulting commodity price declines, which could cause its own collateral damage.

As an investor, I am not much exposed to commodities, and a little exposed to financials. Some of that is by accident - I tend to focus on other areas of the economy, but I also have an aversion to asset bubbles, even if that means missing some of the upside.

Comments

[Robespierre:]

There is a lot of talk about money supply not growing and therefore no money inflation. However, are all the $$ outside the US being counted? Won't this money come back into the US to buy food and therefore drive the price off all soft commodities? And aren't that many $$ outside the US because of over printing?

2008 Apr 25 07:46 AM

[CrossProfit_:]

Nice article and appreciate the time you took to write this.

There are several points/assumptions that we somewhat disagree with (speaking for the CrossProfit consensus).

1) "As the US dips into recession, the rest of the world will follow, and demand for commodities will fall (as has already begun)."

Perhaps this is true to a certain extent regarding Japan, Korea, Europe and South America, but we would argue that the growth engine both in India, Middle East and even more so in China will perhaps slow down a bit but will not follow into a recessionary pattern. These countries/regions have enough capital reserve to finance their continued growth for at least three to four 'U.S. recessionary years' and do not have to rely on continued export growth to the U.S. in order to fund their expansion. Rare is the case that a recession has lasted longer than three years in the U.S.

Such being the case, demand for commodities may soften in the western hemisphere only to be picked up on the other side. The severity of the recession is likely to dictate an outcome that overall, commodity consumption continues to grow, albeit, at a slower pace.

2) "Further, high prices will finance the hunt for alternatives, as is also in full swing."

Yes, this is true and necessity is the mother of all invention. However, there are a few pieces missing to this puzzle. We should differentiate between various commodity types. Coal, iron ore, food staples etc., all have the option of alternative or increased production over a period of time that with current technology any demand can eventually be met for the next 25 years or longer.

The same is NOT true regarding energy. Take Saudi Arabia for instance. You might argue that SA can increase production by 3m bpd over the next two years and you would be scientifically correct. The problem is that SA has a strategic plan in place to make sure that their oil lasts for another 40 to 50 years. This means that they simply won't do it.

Europe has spent the last decade preparing for this event while the U.S. has lagged terribly in this area. For instance, the majority of mass transportation has been upgraded to run off of electricity (fast trains) and many European cities are either running trams or are building/updating old infrastructure to switch to a tram system.

Even little Israel is building a tram system in Jerusalem and a fast train system on its number one traffic route; Jerusalem-Tel Aviv.

The advantage of 'electric transportation' is that the electricity can be produced by a number of methods and is not locked into oil as the internal combustion engine is. Those that wish to argue that NG and hydrogen are viable substitutes will face the insurmountable distribution problem. Others have tried the NG alternative and unless there can be a guarantee of sorts that NG will continue to replace 'petrol' for a 25 year minimum, no one will invest in the necessary infrastructure needed for proper implementation (including the 'home tap' refilling system).

The U.S. is now consuming 1% less gasoline than a year ago, however, the rest of the world more than makes up for this lost consumption.

3) "In general, I believe the inflationary pressures we are seeing now are a function of a speculative bubble in commodities, magnified by derivative leverage. I don't believe that the price levels in commodities (or currencies) are sustainable long-term, unless the Fed gets reckless with monetary policy."

We agree to a limited extent that there is some froth built into the current prices, in oil and NG as well. However, whereas a year ago if $65 was the fair market price for oil, using current dollars, oil would now be at $78. In other words, the intrinsic value of the currency contributes 20% to the price rise and this is for the last twelve month period alone.

For a more accurate calculation, use the spread between the increase in U.S. dollars and between the Euro for oil.

As to the Fed, we are on record here at Seeking Alpha as stating that the Fed should have cut rates sooner and then their would not have been a need to cut so deeply. Now they will have to raise. The timing is disputed (internally at CrossProfit), but we should start seeing high inflation figures in May/June. This is inevitable as the continued decline in real estate can no longer offset the rise in oil.

This leads to a chain reaction in all other CPI components. Though food and energy are removed from the monthly figures, the two are key feeders into the system. When both go up 3% in a month, you can literally guarantee that at least a third of their collective average gets pushed through to the CPI over the following two months. Deflators, such as housing have already done their bit and have little left to contribute. In a year from now we could start seeing lower housing sales on HIGHER prices as inflation erodes the purchasing power of the Dollar for everyday items. The lag factor is a bout a year.

The above scenario is based on the Fed losing the war on inflation by not raising rates on time, as stated in your article.

4) "When the price of risk is high and/or when debt is not available, commodities become one place to invest."

We are not sure that we understand what you mean by this but if you are saying that investors turn to commodities by the droves and bid up the price artificially based on supply and demand BECAUSE debt is not available, we fundamentally disagree with this assertion.

Once again, nice thought provoking article.

CrossProfit

2008 Apr 25 08:27 AM

[User 143167:]

With huge amount of ARMs waiting to implode if the Fed raises rate again, the Fed has pretty much surrendered its weapon to fight inflation.
For anyone who believe the Fed will certainly raise rates should check this logic out:
1, The Fed and government want to reflate the economy and housing prices to avoid recession.
2, The rising interest rates is the REASON to pop this housing bubble.

So the Fed has no way to raise rates before the housing market bottoms out, which will take a long time.

2008 Apr 25 08:29 AM

[Lilguy:]

Greatly appreciate your efforts to put together this comparative analysis. It is very useful in corroborating or debunking others' claims that our current situation is "just like" (pick your recession/depression). It's useful to have this tool to give a check on those assertions. Thanks.

2008 Apr 25 11:16 AM

[L Moore:]

Nice essay. Comparing today's inflation and unemployment numbers with those of the 1930s just doesn't work because different formulas have been used. Today's 5% unemployment maybe 12% if the older formula were used. And inflation? If we knew what the rate of M3 was then we might have a better understanding of the situation.

But, you're right, each event is different. They can all be called systemic crises which is an egghead way of saying the economy is out of whack.

2008 Apr 25 11:47 AM

[David Roskoph:]

Thank you. Markets rhyme, not repeat. It is a constant experiment and the Federal Reserve can only maintain control of their monopoly by inflation. In a deflation they lose control and relevancy. The recent experiment is to feed the market as much credit as it wants and have more ready if it falters (the fiat put). Now we are (again) at the end of that multi-decade game and it is not possible to reflate this bubble. Deflation is axiomatic.

2008 Apr 25 01:14 PM