How The Dollar And Trade Have Helped Tame Inflation - Stagflation Next

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by: Jason Tillberg
Summary

The US dollar's strength plays a pretty big role in the rate of inflation.

Imports still play a major role in the US economy's input costs.

The recent trend in the year over year dollar change is slowing, and the future of the dollar will heavily impact our rate of inflation.

A weakening dollar will prove a fierce inflationary force.

How stagflation is a real possibility.

To help be a better investment forecaster, I think it's critical to understand the past. To know what's been, so as to know what'll be again.

The strong dollar and slowing credit growth have certainly contributed to the slowdown in inflation of late. The future of inflation is probably going to be higher, but it's quite uncertain. Having as much knowledge about the factors that affect inflation can only help make the uncertainty less uncertain.

I spend a fair amount of my time thinking about the entire period of post 1971, when President Nixon closed the gold window, and the impact on the economy, dollar, interest rates and investment returns across all assets.

The gold window was what allowed foreign governments to use their dollars to buy gold from the US at a fixed rate of $35 an ounce. For US citizens, it had been illegal to own gold since 1933.

The ramification of investing post that become enormous. Gold went crazy, inflation soared, productivity collapsed and we had what was known then as the misery index, i.e., Inflation + Unemployment, for the first 10 years of having closed the gold window.

Then, around 1981, something happened that changed everything. The inflation problem was tamed, the productivity problem was cured and the economy boomed over the following 5 years especially.

The one thing that should really stand out is that from 1981 to 1985, the value of the US dollar soared versus our trading partners' currencies. Obviously, this made imports from these countries, like Germany and Japan, much cheaper for US business and consumers, which is deflationary. Input costs dropped, and that helped improve productivity.

At the same time, commodities like oil, priced in dollars, collapsed in price, which was a deflationary force.

Below is a chart of the US dollar trade weighted index from 1973 to 1988:

The value of the dollar nearly doubled from 1981 to 1985.

The next chart I want to show is imports and exports as a percent of GDP:

In the 1970s, the US had to start importing oil, and that contributed to higher imports as a percent of GDP.

As soon as the dollar began to rally in 1981, our exports as a percent of GDP began to decline, while our imports as a percent of GDP stayed relatively flat.

The rising dollar meant we were importing more goods and services at lower prices, so even though as a percent of GDP they were flat, imports were rising.

At the same time, we imported less oil even as oil priced collapsed. Oil prices went from $37.89 in 1980 to $14.43 by 1986!

Productivity picked up strongly in the 1980s too, partly due to the strong dollar helping to reduce input costs, which is again a deflationary force.

The end result of all these deflationary forces in the early- to mid-1980s was that not only did it tame the rate of inflation, but it allowed for massive amounts of credit to be issued while inflation would remain low.

Hence, the 1980s proved to be a perfect storm of good times to make a lot of money!

Here is the final chart from this lesson from the 1980s showing the year-over-year rate of credit growth (blue line) versus the rate of inflation (red line).

Inflation would go from nearly 15% in 1980 down to just 1.18% in 1986.

Lesson Learned From The 1980s

You can kill the inflation beast with a strong dollar coupled with increasing the amount of imports of goods and services from lower-cost countries. The benefit is that you can get away with issuing a lot of credit, and it won't be inflationary.

Credit is what pays for everybody's raises at their jobs. It pays for profit and dividend growth. It pays for the previous years' interest on debts. It's where the money comes from to do the leveraged buyouts too.

I think that this formula for inflation success has had a large influence on why we created NAFTA and why China was allowed to join the WTO.

America had become addicted to the deflationary forces of importing deflation. Same goes for the dollar being strong.

It's been, in my opinion, a Faustian bargain. The cost of this policy is that we've run large trade deficits for so long that now the level of foreign ownership of US assets is nearly $10 trillion more than Americans' ownership of assets of the rest of the world.

Why Inflation Is Low Today

First and foremost, it is credit growth per capita that is the baseline for inflation. From there, you have all your inflationary or deflationary forces that include currency, productivity, imports or exports and commodity prices.

Credit growth per capita is neither breaking out nor breaking down. It's been in an upward trajectory with a wave-like pattern. The wave has been on the decline, however.

The blue line is your credit growth and the red line is your rate of inflation.

In the first quarter of 2019, credit growth per capita grew 3.57% year over year and was down from growing 4.34% in the second quarter of 2018. Credit growth is slowing, and that is a deflationary force.

Trade

The widening difference in credit and inflation from the 1980s was mainly due to the strong dollar and trade. In the 1990s and 2000s, it was NAFTA and then China joining the WTO that were our key deflationary forces that contributed to the large credit booms up until the last recession.

Here is a chart showing the % of GDP of the difference between our exports and imports of goods and services:

We are flatlining around -3% of our GDP, so there is neither a deflationary nor inflationary force at hand currently from trade.

Dollar

First, here is a long-term chart of the trade weighted dollar index:

As you can see, the dollar is nearly at all-time highs against foreign currencies. This has certainly been a deflationary force since it started rising again in the Fall of 2014.

Let's take a closer look at the relationship between the year-over-year % change in the dollar versus inflation:

There is a clear impact where, as the dollar gains in value year over year, inflation pulls back. Inversely, as the dollar weakens year over year, inflation picks up.

Since the beginning of 2019, the dollar was stronger year over year, and that has impacted inflation to the downside. However, the year-over-year gains in the dollar are running out. By the Fall, we could see a weaker dollar year over year - and that'll be an inflationary force.

Conclusion

Inflation has been coming in on the low side due to slowing credit growth and a strong dollar. The dollar has been probably the biggest factor in taming inflation. The greatest risk is that there is not much left to tame the rate of inflation relative to the rate of credit growth in the years ahead.

Inflationary forces may well outweigh deflationary forces in the quarters and even years ahead.

There is little impact on trade with respect to inflation or deflation forces at the current time, as the trade balance hovers around -3% of GDP. This needs to be monitored with all the trade deal talk. If the deals work out where Americans export more and import less, that'll be an inflationary force.

The recent tariffs, however, might prove to be a somewhat inflationary force in the meantime.

The dollar is not going to be showing as strong a year-over-year percent change, so that will lessen its deflationary force and may even prove inflationary by the Fall.

Add this all up and we're likely to face inflationary times in the quarters and years ahead, which could very well prove to be a return of stagflation.

This should warrant investors to demand higher interest rates on their debt instruments, so bond prices could fall as their rates rise to reflect higher interest rates.

The future is quite uncertain.

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.