Inflation or No Inflation?

[Donner]

Questions for the Board: What are your feelings about inflation in the U.S.? Do we have a problem or don't we? Fed meeting minutes of 3 weeks ago seem to have touched off an uproar in the markets -- of real concern or passing worry of the day? Is the outlook for continued price stability or a more adverse inflationary environment? What are the implications for the bond markets and the equity markets? Should retirees be concerned?

Some thoughts to ponder while you noodle on this:

Arguments for continued price stability:

1. China : deflationary pressures in manufactured goods
2. Demographics : western societies getting older and consuming less
3. Lack of global demand : Chinese/Japanese/Europeans not consuming
4. Wage growth : as in there is none
5. Growth in productivity : make more with less
6. Idle plant capacity

Arguments for higher inflation:

1. Strengthening economy
2. Weak dollar policy : US dependent on imports
3. Higher energy costs : oil going back to $50 bb
4. Twin deficits : Budget and Trade deficits as far as the eye can see
5. Job growth
6. Increased commodity costs
7. Accommodative Fed monetary policy

[charlie]

Well I just made a big bet by putting 1/2 of my
fixed income allocation in a long term floating rate
CD that pays 2% + CPI. Inflation will probably
tank now.

Cheers,

Charlie

[brewer12345]

I have news for the Fed. If there was lots of inflation in the second half of the year, it wasn't coming from commodities. Commodities dropped some 7+% over the last 6 months of 2004. So if inflation is starting to rear its head, it is likely coming from two places:

1) Labor costs are finally starting to outstrip productivity gains

2) Capacity utilization is finally starting to pinch (after 4 years of slack capacity)

This says to me that we will see rates being raised, but not tremedously quickly. Note that long term rates (10 year treasury) are still in the low 4s, so the bond market doesn't necessarily expect a big jump in inflation long term.

Yeah brewer, I've been surprised how slowly interest
rates have moved. That's good for me at present as
I am mostly locked in on long term bonds. OTOH, I know
it can't last forever. Or, can it?

JG

[Donner]

Bill Gross in this week's Barron's says we are in a tug of war between the deflationary forces represented by China's cheap labor vs the reflationary forces represented by the world's central bankers trying to stimulate consumption and full employment. He bets the central bankers will win.

We have been in a pretty long stretch of relative price stability but I think things may be slowly but surely changing. We may wake up one day and discover the CPI is all of a sudden up 5% year over year. Kinda like hopping on the scale and discovering your up 10 pounds.

[Donner]

JG--

The lack of movement on the long end of the yield curve is a puzzlement.

One camp says that this is the market's way of telling us that there is not going to be a surge in inflation any time soon.

Another more plausible explanation to me is that the current Fed policy on short term rates is constraining movement at the other end of the curve. The argument goes something like this: With the Fed creating a negative real interest rate environment at the short end of roughly -1.5% it encourages the "carry trade" to perpetuate itself long after its usefulness as a counter recessionary tool of national policy has ended. As you know, participating in the carry trade is like printing money. You borrow short at -1.5% real and lend long at 4.5% to the Government. Just pocket the difference and plan your trip to the Bahamas! Those Wall St guys get paid 7 digits plus bonuses plus stock options for their expertise in this area. So, what you have is intense competition to lend long. Let's see: My competitor says he will borrow short at -1.5% real and lend $1 billion to you long at 4.5%? Have I got a deal for you! I'll borrow short at -1.5% real thanks to my buddies at the Fed and lend you that $1 billion for 4.49999%. Deal? This carry trade feeding frenzy among the big lenders and their Senior Vice Presidents looking for their bonuses is what is keeping the long end down. When will the game end? It won't end under a policy of measured teeny tiny little rate hikes every 4 to 6 months. That leaves the door wide open for the Wall St. crowd to shift the risk as the profit margins shrink only gradually over time. The game ends only when the Fed makes a surprise unanticipated substantial hike at the short end sending a clear signal that it is unwilling to subisdize the carry trade any longer. You will see a scurrying to unwind both the short positions and the long positions by the big boys which will move the long end of the curve up. Until then the little guy is going to have to be content with the rate scraps from the table. Keep your eye on Sir Alan !

Donner

[Helen]

Quote:

What are the implications for the bond markets and the equity markets?

Well, I just moved a bunch of money from the S&P 500 into short term securities and international equities. This is a very strong indicator that the US lg cap stock market will rise.

-helen

[Donner]

Helen--

That's usually the way it works for me, too!

Donner

[Roger_R]

I'm still a novice at learning about interest rates, but it's my understanding that longer term rates will begin to raise when there signs of rising wages (and seemingly thus, inflation risk). So far, unemployment advances, if any, are in lower paying jobs. Also, a far lower percentage of corporate profits are going into the workman's pockets than historical trends, but instead into off-shore outsourcing and highly compensated corporate execs. So I'm thinking slow or no inflation and slow or no long term interest rate increases. Until oil prices rear their ugly head again.

[brewer12345]

Quote:

JG-- * * *The lack of movement on the long end of the yield curve is a puzzlement. * One camp says that this is the market's way of telling us that there is not going to be a surge in inflation any time soon. * Another more plausible explanation to me is that the current Fed policy on short term rates is constraining movement at the other end of the curve. *The argument goes something like this: *With the Fed creating a negative real interest rate environment at the short end of roughly -1.5% it encourages the "carry trade" to perpetuate itself long after its usefulness as a counter recessionary tool of national policy has ended. *As you know, participating in the carry trade is like printing money. *You borrow short at -1.5% real and lend long at *4.5% to the Government. *Just pocket the difference and plan your trip to the Bahamas! *Those Wall St guys get paid 7 digits plus bonuses plus stock options for their expertise in this area. *So, what you have is intense competition to lend long. *Let's see: My competitor says he will borrow short at -1.5% real and lend *$1 billion to you long at 4.5%? *Have I got a deal for you! *I'll borrow short at -1.5% real thanks to my buddies at the Fed and lend you that $1 billion for 4.49999%. *Deal? *This carry trade feeding frenzy among the big lenders and their Senior Vice Presidents looking for their bonuses is what is keeping the long end down. *When will the game end? *It won't end under a policy of measured teeny tiny little rate hikes every 4 to 6 months. *That leaves the door wide open for the Wall St. crowd to shift the risk as the profit margins shrink only gradually over time. *The game ends only when the Fed makes a surprise unanticipated substantial hike at the short end sending a clear signal that it is unwilling to subisdize the carry trade any longer. *You will see a scurrying to unwind both the short positions and the long positions by the big boys which will move the long end of the curve up. *Until then the little guy is going to have to be content with the rate scraps from the table. *Keep your eye on Sir Alan ! Donner

Donner, you were doing great until you started talking about the carry trade. These positions have mostly been unwound a while ago. One of the reasons the Fed played around and hinted for so long is that they were trying to get all the carry trade players to cut it out so that they didn't have to deal with scores of crippled financial institutions. Most players got the message and unwound before the Fed started raising rates, but some didn't. Check out NYB for an example of a management team that was asleep at the switch and the damage they managed to inflict on their shareholders.

I think long rates are still low for two reasons:

1) Asian exporting nations continue to dump the dollars they earn into long treasuries, depressing rates.

2) demand for credit on the part of large corporate borrowers has been very, very low for several years now, since nobody wants to invest in more capacity and balance sheets are generally flush with cash.

I suspect we will see long rates start to move up as the economy hits the point where additional production capacity is required and corporates start raising funds in order to put new capacity in place. Since we are still under 80% capacity utilization, it will be a while, but the day is getting closer.

[Marshac]

Quote:

Since we are still under 80% capacity utilization, it will be a while, but the day is getting closer.

Lord knows when that will happen... this Christmas, just for fun, I looked at the country of origin for everything under the tree. With the exception of ONE item made in the US, everything had come across the Pacific from China. Merry Christmas to them I suppose.

[Donner]

Roger_R -- I think your observations are right on mark. It is undoubtedly true that you can draw a significant historical correlation between inflation and employment and wage growth. In fact, it is very hard to envision significant inflation in the U.S. without full employment and fat wallets chasing consumer goods. Problem is, as you point out, Bush's 2 million new jobs are at the low end of the scale and the country is awash in cheap China junk. Not enough disposable income in the middle class chasing too many goods. I think we will be getting a gradual cost push from rising materials and interest costs over some extended period. But in view of your scenario, companies are going to have to eat those costs in the absence of a lot more exports. But why should foreigners buy American junk when China and other emerging economies can produce the same junk cheaper? Corp profits are going to moderate as a consequence. These are the deflationary forces which Bill Gross talks about.

Some people are describing the current economic environment as a Goldilocks Economy. Not too hot and not too cold. Relatively low unemployment, GDP expanding at a real 3% to 4% rate and a nominal 6%, low interest rates, low inflation, profit and dividend growth in double digits. See Lawrence Kudlow --Barreling into 2005. OTOH some people might view the same set of data as indicative of a middling, to piddling, to squishy, to WEAK and VULNERABLE economic performance, especially from a working man's perspective. So there may be a blind spot growing in the national data that does not reflect a widening gap between corporate economic health (nominal balance sheets and income statements) and Main Street Mr. and Mrs. America's economic health. (nominal balance sheets and income statements)

So you come to the other side of the deflationary/inflationary tightrope that Bill Gross keeps talking about and that is the role of the central bankers, particularly the Fed. You'd have to conclude that the Fed is mighty leery of the sustainability of this Goldilocks Economy. If the economy is in such fine fundamental shape, good and getting better as Kudlow maintains, why would the Fed keep the priming pumps working overtime to flood the system with added liquidity and cheap credit? Result is asset bubble pricing in all asset classes now, particularly in real estate. The cheap Fed made dollars have to go somewhere. Not to mention a dollar that if its not in an actual nosedive is surely approaching the diving board. Fed policy apparently is to keep the consumer borrowing and going deeper and deeper in debt to keep the whole shebang from falling off the tracks. Recall that only a short while ago, the Fed was actually publicly ruminating on the dangers of deflationary recession. Well, we have been in a dump the dollars out of the helicopter mode for quite some time now. If the Fed can't see fit to tap the brakes firmly now in a Goldilocks Economy what kind of economy is it going to take. And if they don't, or can't, reverse their current policy path without inducing a deflationary recession, what is the end game for America? Pure and simple, I think the Fed is just playing for time hoping the imbalances in the system work themselves out somehow.

So bottom line: I think you are right for the time being. Low inflation thanks to China, low interest rates thanks to the Fed and its helicopter, low job growth thanks to China, low wage growth thanks to China and Mexico, continued asset price bubbling (including more ghastly increases in real estate prices, probably modestly higher common stock prices, and not as bad a hit in the bond markets as people may fear) thanks to the Fed, skyrocketing personal debt levels thanks to the Fed, and further inevitable declines in the value of the currency thanks to the Fed. In short, a pretty good year in 2005. All in a Goldilocks Economy. So, as you skip along Gross' tightrope in 2005, put one foot in front of the other, keep moving, close your eyes, don't look down, and, think happy thoughts!

Two caveats If the Fed sobers up and takes away the punch bowl as it morally should, or, alternatively, if U.S. consumers finally tell Sir Alan to shove his cheap credit, all bets are off. But I don't think there is much chance of that, do you?

[Donner]

Brewer-- I have read accounts that Wall St. has taken the opportunity afforded by the Fed's foot dragging to unwind its short positions and hedge its long positions to gradually liquidate the carry trade in an orderly and measured manner. What Wall St. wants from the Fed, and has obtained apparently, is lots of lead time from the Fed before it acts precipitously to tighten credit. In other words give us clear signals, a six months head start, to get out of Dodge before you put the hammer down. Nice. Kinda like letting the bookies know when the raid is coming. But, you know, I think when you have the power to print money its pretty hard to resist. They may be shifting the risk through hedging transactions but the game is still afoot, IMO. Whether they are or are not getting out of the carry trade, the basic equation is that long rates are being determined by the supply of credit. Whether the supply comes from China, or Japan, or Europe or from J.P. Morgan and friends the result is pretty much the same. And the Fed is undeniably aiding and abetting and fostering this credit creation. So we have folks with fistfuls of funds to lend and invest chasing around after deals. All kinds of deals from U.S. Treaury offerings, commercial loans, consumer debt and dozens and dozens of pre-approved credit cards in the mail, home mortgages, HELOC, zero percent car loans, low low prices with no payment to January of 2007 etc. etc. etc. I agree that a basic problem is finding commercial deals when capacity utilization is at historically low levels. So I guess the game goes on until China and Japan have had enough or the Fed decides that dropping more dollar bills out of the helicopter is no longer having the desired effect. But I don't see that happening any time soon. So, I guess the message is-- party on, America, and have a good 2005!

[Donner]

Marshac--- Had the same experience at China Mart. Except in my case it wasn't Christmas but last 4th of July. Went in to buy some patriotic stuff to wave around and found that all the American flags were made you know where. Looked around the rest of the store and could hardly find anything made in the U.S.A. China Mart stock may be a little vulnerable if the dollar keeps dropping and China revalues.

[Marshac]

Quote:

Marshac--- Had the same experience at China Mart. *Except in my case it wasn't Christmas but last 4th of July.

NO KIDDING! EVEN MY FIREWORKS WERE FROM CHINA! WHAT'S NEXT?? THE PLASTIC EASTER EGGS FOR EASTER??

On another note:

Yesterday was my birthday... I bought myself 1000 canadian maples... i'm happy, but my girlfriend is pissed. I guess before you go off and buy precious metal, make sure all your bases are covered.... oh well.... I guess now that i'm fully stocked, I can take a tip from the lord of the rings.... forge my own darn ring for her... one ring to rule... nevermind....I suppose I should stop being cheap and get her what she really wants.

[haha]

Quote:

Yesterday was my birthday... I bought myself 1000 canadian maples

Let me see if I understand. You bought about $425,000 of gold coins?

Wow! Impressive allocation. I want to you to know, that I really, really hope you make out like a bandit.

Because we are flyin' in the same plane. However, I am in coach Or maybe stowed away in the wheel wells.

PS: No wonder your girl was miffed. She might have felt that her gift was a bit insignifcant next to your glowing pile. Tip-next time you do the Goldfinger thing, consider doing it on some random day- not a birthday, Christamas, or need I say it- VALENTINE's day.

Mikey

[Marshac]

10:1 silver:gold maples *

They also come in different sizes, not all being 1oz. My gold coins are only .1oz coins. Believe me, i'm not THAT rich.