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[Old Frank P]

This Week With Donald Coxe

Don's Latest Call -- Real Media
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The inflation bogey -- DONALD COXE

For a quarter century, the premier battleground for the ongoing dispute about the outlook for inflation and interest rates has been a futures pit a block from my office -- the Chicago Board of Trade. Befitting the board's history as the world's leading futures market for grains and soybeans, a mammoth statue of Ceres, goddess of agriculture, graces the peak of this landmark. If Ceres' concerns were still the backbone of the board's business, the financial history of our time would have been very different.

In the 1970s, some of the board's leaders began to realize food wasn't the stuff of financial progress. Working with brilliant thinkers at the University of Chicago, they devised a new kind of futures instrument -- the U.S. treasury bond contract. It didn't cover a specific bond, because bonds mature, and no single issue would be big enough to back a major futures contract. What the T-bond futures contract covered was -- and is -- a synthetic bond representing all long-outstanding treasuries. When this contract began trading, investors finally had a convenient, highly liquid vehicle for making simultaneous bets on the outlook for inflation and interest rates. (Gold is an excellent inflation hedge, but it is subject to the vagaries of central bank selling and is expensive to store and insure.)

For more than two decades, the activity in the T-bond pit has been a good gauge of investors' outlook on inflation, and how the Federal Reserve will seek to control it. Most of the time, prices in the pit trade in a narrow range compared with the swings in the Standard & Poor's 500 futures pit 10 blocks away at the Chicago Mercantile Exchange. In recent weeks, those pits have swapped roles. The bond pit has been the scene of the biggest price swings since the Crash of 1987, while the S&P pit has experienced reduced volatility as investors try to digest the stock market's big runup from the September panic lows.

What is unfolding is the latest chapter in the central economic and financial debate of our lifetime: what will happen to inflation? After the double-digit agonies of the 1970s, Paul Volcker, Margaret Thatcher and Ronald Reagan vowed they would slay the beast. Just about nobody believed them. In part, this skepticism was rooted in Club of Rome thinking. Since 1970, that collection of modern Malthusians, including Pierre Trudeau, had been meeting (in Rome, naturalmente) to wine and dine sumptuously, then emerge to predict global food and commodity shortages. Oil, metals and grains would be scarce forever, creating perpetual inflation, crises and wars.

As if those gloomy prophecies weren't enough, economists cited the ways in which inflation was ingrained into democratic economies: governments had to keep raising expenditures to create jobs and pay the endlessly mounting cost of social and health benefits. Those expenditures would be financed by rising taxes or deficits -- each of which was ultimately inflationary. Unions -- particularly public-sector unions -- had the power to bring the economy to a halt to enforce their demands for large wage increases with full inflation protection. Central banks were thus forced to print too much money to offset the rising costs of wage settlements and handouts.

No wonder investors concluded they had to protect themselves by buying oil wells, silver and gold. Bonds were horrible investments, and even stocks weren't safe because governments could grab the inflation-generated gains. (Canada's National Energy Policy was only the most egregious example.)

We now know the experts were wrong. Since Reagan and Thatcher's early years in power, inflation has been in secular decline globally. In each five-year period since 1981, inflation shrank, and in each cycle it fell harder than economists, investors and the public anticipated. Three inflationary decades had "proved" to all who would think about it that inflation was part of the human condition. Unlike smallpox and polio, it was ineradicable.

Long-term fixed-rate bonds are the worst-performing asset class when inflation rises more than investors anticipate. Conversely, as Canada's history since 1981 has demonstrated, they are the best-performing asset class when inflation falls much more sharply than anticipated. (Think how happy you'd be today to be holding the Canada bonds trading that year with 18-per-cent yields. Such yields were available on long bonds because both Ottawa and investors assumed double-digit inflation would last forever.)

Over at the board of trade, the old skepticism is returning. Long-term rates have risen sharply even as recorded inflation touches new lows under the hammer blows of a new force -- deflation. Economists again say (as they have so regularly since 1984) that the good news on inflation is over and again dismiss talk of deflation as absurd.

The performance of the global economy and financial assets hinges on the outcome of this latest outbreak of the inflation debate. I'll give you my take on that story next week.

Donald Coxe is chairman of Harris Investment Management in Chicago and Toronto-based Jones Heward Investments.

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