Big Money Is Betting on Inflation, Not the Economy

Investors may wonder how the market can possibly rally when the economy resembles a punch-drunk boxer hanging on the ropes. The answer is fairly simple: the big money is not betting on the economy it is betting on inflation.

The Fed is printing money as fast as it can — in order to save the banking system from annihilation. Nobody gets up off the canvas without assistance after taking a 1 trillion dollar sock on the jaw. While the Fed can provide liquidity, there is only one way to protect banks from falling asset prices which threaten to wipe out their reserves. That is to create inflation — to reverse the fall in asset prices.

Investors and financial markets response to low interest rates from the Fed is to borrow all that they can and invest in real assets in anticipation of rising prices. This becomes a self-fulfilling prophecy as demand for real assets exceeds supply, driving up prices... and the next asset bubble is born.

The Fed does not mind, as investors mop up surplus money in the system and prevent it from flowing through to consumption — where it would affect consumer prices. Economists thought that they had found the holy grail. They could stimulate the economy without any significant impact on consumer prices. Only to discover that it is a poison chalice. There is no quarantine fence around asset bubbles and eventually higher asset prices flow through to consumers. When average workers can no longer afford to buy their own home, upward pressure on wages starts to rise. And when asset bubbles burst, as they are prone to, causing severe shocks to the economy, the Fed's only available response is to... you guessed it ... print more money and start the next asset bubble. The ever-increasing shocks are eroding the ability of the economy to recover and grow in a stable, predictable environment.

So where is the next asset bubble likely to occur? With wounds from collapse of the housing bubble still fresh, there are only two viable alternatives: stocks and commodities.

Inflation targeting by central banks is a major cause of bubbles. Inflation targeting is based on CPI which is a poor measure of the loss of purchasing power of the dollar. Why have house prices doubled in the last 5 years if inflation is averaging between 2 and 3 percent? Not to mention gold, oil and most other commodities. By using CPI as a measure, the Fed responds to crises long after the real damage is caused. Ever tried to steer your car while looking through the rear window to see where you are going? No wonder the Fed crashes into the sidewalk every time they encounter a bend in the road.

If you believe this is all too complicated and best left to a bunch of academic economists and self-interested bankers to sort out, allow me to remind you that the definition of stupidity is to repeat the same action and expect a different result.

Dow Jones Industrial Average

The Dow retreated on Friday morning but rallied towards the close, ending near the day's high at 12900. Failure to react to bad news is a bullish sign — as is a short retracement at the resistance line (12800). Low volumes, however, indicate that the rally does not result from buying pressure, but rather from the absence of sellers — warning us to proceed with caution.

click to enlarge

S&P 500

The S&P 500 is testing resistance at 1400. Breakout would offer a medium-term target of 1500 — and confirm the Dow Industrial and Transport Averages signal. Twiggs Money Flow trough high above zero indicates strong short-term buying pressure.

Comments

[CrossProfit]

Article could have been shortened to the title as it is correct and says it all!

CrossProfit

[galewhitaker]

Wait, how does this work? Inflation has an incredibly damaging effect on the all important consumer. If the consumer can't afford to drive or shop he can't keep up his end of the bargain. With no consumer spending the GDP is going to tank. I will bet that no matter how stupid the investing public is they are not going to go along with rising stock prices and falling GDP values.

[iThinkBig]

Exactly Galewhitaker, inflation is the result of a devalued dollar by printing and lowering rates. While this has helped exporter a tad and multinational corporations, it is not fixing the problem with the consumer. What needs to help the consumer in real terms is raising wages and stopping inflation. How can either happen when the Feds fix is increasing inflation and America has less of the goods the global consumer wants?

[nukldrager]

galewhitaker... My questions too. Talking about $200 oil, or $70 oil if they boost the dollars value 10%... who's side is the gov on? Why is that even a question if it's in their power to do. $200 oil kill's a lot of consumers dead. GDP has to shrink to what $5 trillion? Dramatic maybe, but this stinks of an agenda that one can't find written between the lines.

[sorgmot]

Thank you for the very informative chart. Notice how volume rises when prices fall in January 2008 and again volume increases when prices fall in March 2008. Then notice that volume falls when prices rise in April 2008.

We believe that the standard market advice "sell in May and go away" should get serious consideration in May 2008. Over history, we see 9 month waves in stock market index price patterns which if applied in 2008 would indicate another low spot in October 2008.

We believe the USA stock markets are now going through the declining index price part of the standard business cycle. We expect that should end by October 2009.

We could be wrong and advise you to see your own advisers before making investment decisions.

[flyoverman]

The answer to your question: "How can either happen when the Feds fix is increasing inflation and America has less of the goods the global consumer wants?"
..is... the lower US dollar means foreigners are finding American good a better deal, and they will be (and are) bidding up the prices.

[Marol]

Dear Galewhitaker: The consumer will continue to drive (absent carpooling and public trans) as long as it's necessary to EAT -- so commodities prices can safely go up (esp since there are now shortages of many staples, so it takes less buying to use up what's there). In this country, we are experiencing less of a rise bec we use commods less directly -- for example, we buy ready-made bread.

Even so, look at what's up the most -- cheese, eggs, beans and I'd guess chicken (haven't checked) -- exactly what poor people depend on. Don't expect much change until the agribiz lobby is pushed back on ethanol. Eventually (2 years? I'm optimistic) public pressure will have an effect. By then, lots more overseas deaths from hunger of course -- but that's not crucial for us, is it now.

I heard an "insider" on NPR a couple of days ago explaining that in the 70s a decision was made to back financials rather than industry, which is why it's financials that are bailed out. (One big exception was for an airline.)

Public has stood all this in the past, in prior recessions ( and esp stagflation (70s -- Nixon!!! froze price increases). Many other times where the prices have gone up hard for the poor, officially unnoticed. They keep changing the definitions so we can't tell -- for example, taking food and energy out of "core" inflation.

[Marol]

PS Very interesting article and hypothesis. Do you have other indicators besides buying volume (which I guess could have other causes)?

[bdograleigh]

nukeldrager...oil is not going to $70 if the dollar strengthens 10%. I heard this quote as well and I believe it to be utter nonsense unless someone can share some comprehensible numbers to get it there.

[MWM]

The fed is not printing money,it is still tight money policy.
MZM has not increased to any significant degree.

[edhaq$]

Good point wrt the CPI.Take a look at the 'basket of goods'.It includes jewelry and wine but not the price of gasoline and other items that have actually impacted on the cost of living of the consumer in the recent run up.The Fed therefore does not see the need to address inflation because it is not easily apparent in the statistics although we all know that its much higher than reported.In any case current measures are necessarily inflationary otherwise they will not work to avoid a collapse which in any case will come soon enough.A rock and a very hard place! Cheers!

[davy wavy]

The Fed and gov't has put us all on the hook to bail out every bad decision made over the past 6 years and beyond. The dollar must suffer the consequences. The economy must contract. But a collapse...I doubt it. Just more stupidity from our Fed and politicians and a shrinking dollar! We are selling our country bit by bit and becoming poorer and poorer by letting these clowns run things. Buy strong currencies, some gold, silver, and be patient while looking for some great value plays in stocks whenever panic sets in!