In the latest CPI Report published on 3/13/2018, year over year the CPI was up 2.1% marking the 7th month in a row it has logged a reading above 2%.
Based on a long-term trend analysis of inflation, stagflation, not deflation is now the underlying pattern.
The question is whether this trend will extend or subside as it has for the past 30 years.
This article presents analysis of the combination of policy factors that historically correlate strongly with inflation.
The complex interaction of fiscal, foreign and Fed policy will dictate the eventual outcome, and will have a major impact on how investment portfolios should position for risk going forward.
As the first quarter of 2018 progresses, the market continues to be on alert that inflation pressures in the economy may be building. The February CPI report was published on Tuesday (3/13/18) which showed a continued move upward above 2%. Year over year the CPI was up 2.1% which marks the 7th month in a row it has logged a reading of 2% or more. The rebound is being driven primarily by the recovery in oil prices, which on a per barrel basis has now traded above $60 in the spot market for 3 straight months and is well above the $30-$40 per barrel range it was selling for in the winter of 2016. The Producer Price Index (PPI) continued to reflect the surge upward in commodity prices, with the February reading up 4.3%.
Overall the CPI index is at an all-time high and is gathering upward momentum; the PPI index, on the other hand, continues to be below levels recorded at the end of 2014 when the US Dollar surged from 85 to over 100 on the Dollar Index (DXY). The foreign supply chain influence on producer prices is very evident as the DXY is now at 90, and producer prices have surged higher at a faster pace than the CPI as the dollar has moved lower over the past year.
The question being debated in the investment community is whether the US economy is on the verge of experiencing more rapid inflation than it has in the past 10 years; and, additionally whether the deflationary drag on prices that has been evident in the inflation data for the last 20 to 30 years, with the exception of the oil spike from 2006 to 2008, is beginning to reverse. If inflation or stagflation is returning to the US economy (and the jury is certainly still out on this issue as data presented in my previous article on the inflation Why Can’t Fed Rate Policy Inflate Main Street?), investors need to position their portfolios differently for the risk than they would in a deflation driven market. The go to playbook in times when US stocks peaked and began to decline over the last 20 years was to hide out on the long end of the duration curve in the 10 and even 30 Year Treasury as market panic produced a risk-off trade that sent investors scurrying for assets that were counter-correlated as stocks fell.
But here is an important message for readers of my articles.
The long-end of the Treasury yield curve will provide no solace in the event the financial market is experiencing a strong inflation trend or worse a stagflation trend, as was the case in the late 1960s and throughout the 1970s. Therefore as the market prepares for the next major downturn, one which my research shows is very probable in the near term as explained in a recent post Overfed Stock Market Getting Ready To Go On A Crash Diet, it becomes paramount for investors to know what kind of economic storm they are about to experience in order to avoid making a double edged portfolio re-balancing mistake of staying long duration in the credit market in hopes of hedging a stock market disaster.
Stagflation, Not Deflation is now the Underlying Economic Trend Based on Long-term Trend Analysis
The U.S. inflation trend, when the long-term is reviewed as opposed to simply focusing on short-term deltas, shows a very interesting pattern. And, the pattern reinforces the outlook that stagflation, rather than deflation, is in the process of returning to the US economy. Most recently Alan Greenspan has voiced his opinion that stagflation is also the primary economic condition to be expected going forward. (see here)
I do not know all the data that Alan Greenspan uses to make his assessment. You can be sure it is extensive. But I use a fairly simple time series trend model analysis (4th order polynomial trend line best fit) of real GDP and Nominal GDP over the last 66 years, and reach exactly the same conclusion. In fact, the trend is screaming at a very loud pitch at the moment, and resembles the late 60s early 1970s widening separation between real economic growth and N-GDP, which by definition is economic stagflation.
Which leads me to the primary point of this article – What economic policies can and usually do cause CPI inflation, not just asset price inflation, and if the policies were enacted forcefully would “Make America Inflate Again”? I preface this analytical perspective to a view of the US economy now, not 50 or 100 years ago. There has clearly been a change in the monetary system and international trade dynamics since the 1970s, and particularly since the early 1990s which my research indicates is the point in time the lack of price pressure in the US began to accelerate as a trend.
In order to get a firmer grasp of what is causing the CPI index to remain low even with unprecedented monetary stimulus, it is a good idea to take a look at which consumer prices are moving higher over time and which are not. I found a telling chart which put together by Carpe Diem at www.aei.org which is a great summary of what has happened in the U.S. economy over the past 20 years.
What this chart tells me is that in areas where US fiscal policy has focused on shoveling more and more money into the pockets of consumers to buy domestic based services, consumer price inflation is strong, and even rampant in certain cases. Evidence can be found in college tuition and textbooks (student loans, grants), hospital and medical services (Affordable Care Act), childcare (dependent care tax allowance) and even housing up until the 2008 mortgage crisis, which has since reflated thanks to various government programs and ultra-low mortgage rates.
However, the data also show prices are suppressed in goods sectors where foreign supply chains have made strong inroads into the US economy – cars, clothing, TVs, toys, etc.
Based on the dichotomy over the past 20 years between domestic versus international consumer good inflation, it stands to reason that the suppression of US CPI inflation or the deflationary force in the US economy over the past 30 years can be linked to US foreign policy. I have found several strong structural government policy related factors which are highly correlated to inflation through time, and two strongest correlations have nothing to do with Federal Reserve policy.
It’s the National Debt Relative to Fiscal & Trade Policy Stupid!
Inflation is a monetary phenomenon. It is a measure of monetary waste created by too much money unleashed into the financial system that chases too few available goods or assets. And by definition, if inflation is to ignite in the CPI defined subset of goods and services, those who buy these goods must either have excessive amounts of USD to buy, or the suppliers of the goods must be able to constrain supply to drive prices up. The relative relationship is simple. Many want to tie the deflationary CPI force to technology or demographics. The narrative is interesting. However, I do not find much convincing factual research that accounts for the real deflationary consumer price trends in the US and world economy over the past 50 years, while stocks and bond prices have done the opposite. Old people will buy stuff just like younger ones. Technology will displace workers, but someone has to build, install, maintain and run the technology. And, there is no inherent reason the technology has to be sourced overseas; but it seems to be the chosen path.
In my assessment, the same structural demographic and technology trends, under different US National Debt, Trade and Fiscal policies would produce different inflationary outcomes in the US economy and very likely different real economic growth outcomes as well.
Since 1980, with the trigger point seemingly being stricter monetary policy and President Reagan’s supply-side individual tax cut plan being implemented, inflation has been on a steady downward trend. But, so has real economic growth – the impact on real growth being the exact opposite of the intended outcome.
There are a lot of angles to look at inflation, and believe me, I have crunched the numbers many ways to get a factual, not anecdotal, understanding of just what is suppressing price pressures in the U.S. economy even as the Fed goes non-linear with its monetary policy post 2008, and the Federal Government continues to increase spending programs and go deeper and deeper into debt. None of these actions have been effective in returning wage growth to the US economy, or unleashing unwanted consumer inflation - yet. It is as if the policies being implemented by the US government are purposefully selling out the US growth engine for the benefit of lower priced consumption goods. The historical data certainly can be construed to make this point.
The intersection of all the factors that most directly correlate with inflation based on my research is the way that US Debt policy is managed relative to Fiscal and Trade policy. The deflationary pressure in the U.S. economy since 1980 has been created by continually running trade deficits ($11.5T in cumulative from 1981 thru 2017), while allowing foreign governments to bankroll the conversion of U.S. capital investment (seed corn of the economy) into consumption by financing the growing US Public Debt, now $15.2T as of February 2018, created by the on-going trade deficit.
Prior to 1980, the US trade policy was much more balanced, showing some signs of imbalance through the 1970s as imported oil prices sky-rocketed; but prior to 1972 the country had an almost perfect record of quarterly current account trade surpluses dating back to 1895.
What Changed in Foreign Policy in 1992?
The current account imbalance that has blossomed since 1992 is not coincidental. At the end of George Bush I’s presidency, the idea began to emerge that the Persian Gulf Crisis had ushered in a new world order as the US became the sole military superpower after the fall of the Berlin Wall. Post the Kuwait War, the US foreign policy primary premise became that the US would be obligated to lead the world community to an unprecedented degree, as demonstrated by the Iraqi crisis, and that it would pursue its own national interests within a framework of concert with its allies and with the cooperation of the entire international community.
And a primary tool of achieving that cooperation, as a retrospective review of the data show, appears to have been the selling out of the US real economy in exchange for the fantasy notion of “free trade” to encourage international cooperation. And the manner in which this co-operation was achieved was to allow designated emerging market countries to circumvent the established international trading system rules of balanced trade thru the use of what is known as “dirty float”. Dirty float is the process where a country’s international currency exchange rate is regulated by it government through market intervention in the capital flow account with one of its primary trading partners. It is considered a “dirty” process because in many cases it is a means of manipulating a country’s currency value downward in order to gain market share advantage for certain industries based on its currency exchange rate.
And the US, by virtue of freely opening its borders to goods manufactured in every corner of the world as a policy to encourage world peace and order, opened the door for a new means for countries which may not have the same interest as the US to take advantage of the trading system. The new world order became a dysfunctional selling out of a greater and greater US based production of goods, and the corresponding workforce that produced the goods, in exchange for consumption of International supply of goods. The leading suppliers became Asia based (China, Japan plus others), Germany and Mexico. Each of these governments developed their own means of taking advantage of the US policy shift, but by and large the methodology entailed the hoarding of US currency dollars accumulated through trade, and reinvesting in US Treasuries.
Proven Negative Correlation of Inflation to Dirty Float
Since the dirty float process used by certain International trading partners by design strengthens the US currency above where it would normally trade in a balanced international framework, imported goods primarily from a subset of just 10 countries (China, Vietnam, Mexico, Japan, Germany, South Korea, Taiwan, Malaysia, Thailand and India) since 1992 became relatively cheaper in price through time in the eyes of American consumers. And, additionally, the price of floating more and more debt by the US government became progressively lower in price. The growing debt has been the method used by politicians to pump money into the US economy to avoid a rebellious US population as the take-over of many US industries by foreign competition has left many economic sectors in the country completely decimated.
And the data show that this process of higher and higher amounts of debt by the US government, with a greater and greater percentage coming from foreign lenders has been negatively correlated with inflation (-0.51) in a significant way since 1980. (Note that much of the foreign holding data is actually multi-national companies who did not repatriate USD dollars after moving production overseas in order to dodge taxes. With the recent Tax Reform Bill, these companies do not have to hold these dollars any longer, as the tax on foreign profits has gone to 0%. This does not mean, however, that these dollars will flow back into USD; it is probable that diversification out of the USD may be the actual outcome.)
Federal Reserve QE Policy Not Effective as Inflation Generating Tool Since 1980
And the more surprising information contained in historical Federal Reserve data, is that the FED as it chose to monetize a greater and greater portion of US Treasury debt through Quantitative Easing (QE) over the past 40 years, a process that should by design be inflationary, has been very ineffective. Whereas from 1954 through 1980, QE can be proven to be integral in the process of manufacturing monetary inflation, it has not been so since 1980! Looks like the New World Order may have made a eunuch out of the Federal Reserve Bank.
How are foreign entities circumventing Federal Reserve Policy?
The dirty float process would not necessarily be CPI deflationary, but for the fact that it robs money that previously chased goods and services from US consumers (Main Street), and pushes it into financial stores of sovereign wealth held by fewer and fewer entities who only consume so much stuff, much of which is not American. There is plenty of USD in the system to create inflation, as witnessed by the explosion higher in the stock and bond market in the US, just not money that is going to chase the onslaught of supply of goods being pushed into the US economic system from foreign sources. If the Treasury market (SHY) (TLT) (IEI) becomes saturated as a place for foreign sovereign governments to push investment capital back into the US markets, then liquid capital markets for fixed income securities (LQD) (HYG) and stocks (SPY) (DIA) (QQQ) (VNQ) have now become a very convenient way for the exploding supply of USD in the world to re-enter the US market. Wall Street has recently found a new mechanism for very vast purchases or sales of large swaths of the US capital market through Exchange Traded Funds (ETFs) and Exchange Traded Notes (ETNs). ETFs are very likely to be a contributing factor to market instability in the next major downward stock market upheaval, which under present circumstances is almost surely to be instigated by yet another internationally driven capital flow event.
In fact, once the amount of hoarded dollars by foreign entities reaches a saturation point, meaning the available supply of Treasury debt open to foreign investors is either too scarce, or the foreigners begin to shun the debt in some manner, interesting shocks have surfaced in the US stock market that are completely unpredictable if pure US economic indicators are followed. In other words, the US GDP has become untethered as a reasonable predictor of value in the stock market at least until a dramatic financial market breaking point is reached. The stock market slow roll decline from 2000 through early 2003, and then the major shock in 2008 are two examples of stock market crashes that were more influenced by capital flows on the outset, with the economic recession being recorded after the fact to the surprise of Ivory Tower economists who were busy watching their dashboard of short-term deltas in employment, inflation and GDP. The real instigator of these recessions was the C-Suite reaction to changes in the capital market, which were witnessing major upheaval primarily driven from overseas origins.
US Fiscal Policy Shift since 1992 Caps Inflation
One proven way for any sovereign country to produce inflation is simply to print an ever increasing amount of money through its fiscal policy and hand it out to its population through either legislated programs (or graft and corruption in the case of Banana Republics). And the US historical data show a high +0.59 correlation between the US fiscal spending growth rate and recorded inflation since 1962.
But an interesting twist is evident in the data. Most American’s believe the US debt growth is a function of too much fiscal spending by the American government, and thereby the American public has grown accustomed to loathing Washington spending as the source of the country’s demise. Well, I agree the body politic and their policy decisions are indeed a source of the debt; however, the fiscal spending pattern has been deflating, not inflating compared to history pre-1990. The following table shows the fiscal spending growth trend by decade and shows how the last ten years have actually been a constraining inflation force on economy:
As pointed out earlier in this article, targeted fiscal policies have produced inflation in the US economy over the last 20 years – College, Affordable Care Act, Housing. But by and large the US tax cut driven fiscal policy put money in consumer pockets which flowed to a greater and greater extent into goods supplied by foreign multi-national company producers. As a result, the economy was unable to pay for the tax cuts as wage levels stopped growing, and US based businesses became unprofitable and in many cases went bankrupt. The US tax revenue stopped growing. And, along with it, the fiscal spending stopped growing. However, the National Debt exploded higher.
And the whole pernicious process, which at its origin is created by the perpetual negative international trade deficits fueled by the US blindly promoting a “free trade” policy in a world of “dirty float”, has produced a very strange deflationary economy at a time when the US has pumped major amounts of US National Debt (liquidity) into world capital markets. And this relationship becomes very visible when you look at the relationship in the change in CPI relative to the amount of fiscal spending per year as a percent of the total National Debt. This correlation, which is +0.78 since 1954, shows the highest significance out of all the factors I have examined in explaining the root cause of US inflation, or lack thereof, dating back to 1954.
Before 1980, the US did not run significant trade deficits. And, during this time period, increased tax and spend policies, particularly ones in which the Fed monetized the debt with increasing levels of quantitative easing, produced higher levels of inflation. The real news in this expected result from an economic theory standpoint is that US policy decisions, when out of whack, produced the expected inflationary result. However, US debt during this time period was not significant relative to the size of the US economy, and the foreign influence was marginal until the Middle East exploded in the early 1970s which resulted in a dramatic increase in the USD price of oil on the world market.
From 1980 onward, however, the opposite result has been witnessed. Tax policy shifted to tax cuts, the National Debt exploded higher, and fiscal policy became progressively more constrained, particularly post 1992. And the trade surpluses common before 1980 ceased entirely, and became progressively higher, again particularly noticeable after 1992.
Addressing the Inherently unstable US Trade Policy will unleash the Inflation Rat
US foreign policy since 1992 has purposefully had a blind eye toward the trade practices of a multitude of dirty-float perpetrators in the hope of producing economic co-operation throughout the world post the Persian Gulf War. In other words, the US government has used the country as a giant ATM machine, borrowing against its future ability to produce goods and services in exchange for consumption today and the hope of peace. It has produced a deflationary consumer goods and declining real growth economy. It has also had the ancillary effect of producing unsustainable asset bubble driven stock market episodes which are eventually deflated by international capital flow shifts.
My personal view is that the current US consumption based economy which is nursed by perpetual trade deficits is inherently unstable and should be addressed by government policy. However, there are powerful Wall Street lobbies, many of which are wedded with multinational corporation capital investments (AAPL) built to feed the US consumption economy with a foreign supply chain that cry “protectionism” when any attempt is made to even start to reverse the pernicious process.
Is it really protectionism when the problem has led your own country’s Federal Reserve to be disconnected from Main Street economic policy?
Maybe this is really where the real national defense debate should start, not steel quotas.
Balance the current account deficit in the US going forward and drive the persistent bid out of Treasuries and the bubble bid in US stocks by international buyers and the Federal Reserve will once again have control of monetary policy in the US. But be careful what you wish for, because in this case, given the long period of time that the debilitating foreign policy has been in place, the change back may put the Fed in charge of managing an inflationary nightmare.
Based on the data which correlate most highly to how US inflation is actually created, here is the simple recipe that would assure the Federal Reserve would retake control of the US economic system rather than abdicating it to the deflationary forces emanating from overseas:
With the exception of the last part of the recipe, where the Treasury accommodates as inflation steadily increases, it appears that the Trump fiscal, tax and trade plan is pushing all of these buttons and should have the impact of more inflation based growth in the US. Whether it is real growth or mostly inflation remains to be seen, but my assessment is that it will be very inflationary.
The last part of the recipe, however, is a tricky one to predict, as it is difficult to know exactly where FED accommodation ends and tightening begins in a “bubble blowing” capital market which is detached from actual GDP.
If foreign banks withdraw US market support in protest of the Trump change in direction for US policy and cause tightening worldwide financial conditions, a very real and likely impact as 2018 progresses, the resulting market declines could, and probably will cause a reflexive reaction which will derail the current policy direction. Herein lays the biggest risk in currently buying stocks as US interest rates move higher. The stock values have very little fundamental connection to economic reality, and Fed monetary policy, although proven to have very little correlation over the past 40 years to the deflationary force that has been pushed upon the US economy by US foreign policy, is loaded toward keeping the status quo in place.
Daniel Moore is the author of the book Theory of Financial Relativity. All opinions and analyses shared in this article are expressly his own, and intended for information purposes only and not advice to buy or sell.
Disclosure: I/we 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 (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.