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Good article from Sonders at Schwab

Consumer Woes Run Deep: Welcome Back to the 1970s?
by Liz Ann Sonders, Senior Vice President, Chief Investment Strategist, Charles Schwab & Co., Inc.
June 10, 2008

It was a short-lived sense of nirvana when equity markets rallied sharply from mid-March, giving investors a sense that the worst of the credit crisis and the economy's woes was past. That was before a renewed surge (and attendant volatility) in oil prices and the latest disastrous unemployment report. The consensus in Schwab's Investment Strategy Committee (which I chair) is that we are in the midst of a W-shaped economic cycle, with the pick-up in growth—symbolized by the middle upward part of the "W"—driven by the stimulus package and strong exports. We feel that brief respite is over, and we're facing another bout of weakness, at least rivaling the first leg down.

Unlike the previous recession which hit businesses hardest, this one is walloping consumers. My new Consumer Pain Index combines changes in the stock market, the dollar, job growth, house prices, oil and other commodity prices. As the chart shows, consumers are now under more financial pressure than at any single time since the 1970s. That's consistent with recessionary times. I still believe we are in a recession that began late last year, and the recent uptick in the unemployment rate to 5.5% supports that view.

Consumer Pain Index plunges


Consumer Pain Index calculated using average year-over-year % change of S&P 500 Index, U.S. Dollar Index, nonfarm payroll, median home price (based on new and existing single-family homes), and inverse of oil price and Commodity Research Bureau Index. As of June 6, 2008. Source: FactSet.

CPI = nonsense in the minds of many
Nowhere is the pain being felt more than at the gas station and supermarket. Yes, "core" inflation (excluding food and energy) is contained, but many consumers would respond, "Are you kidding me?!" Until recently, few paid attention to the way the Consumer Price Index (CPI) gets calculated, but given roaring food and energy prices, many are becoming enlightened.

Over the past 30 years, major calculation changes have been made to the CPI due to "reselection and reclassification of areas, items, and outlets, (and) to the development of new systems for data collection and processing," according to the Bureau of Labor Statistics. If you eliminate those adjustments and calculate CPI as it would have been calculated in 1980, it would be nearly 12% today! No wonder I constantly hear from Schwab clients that they distrust government inflation data.

Why inflation feels higher than it is

SGS Alternate CPI reflects the Shadow Government Statistics estimate of CPI as if it were calculated using the methodologies in place in 1980. Pre-Clinton CPI reflects the SGS estimate of CPI as if it were calculated using the methodologies in place in 1990. As of April 30, 2008. Source: Shadow Government Statistics, www.shadowstats.com.

Shadow Government Statistics (SGS), from whom this chart comes, had this take on the above-mentioned CPI adjustments back in 2006: "The CPI was designed to help businesses, individuals and the government adjust their financial planning and considerations for the impact of inflation. The CPI worked reasonably well for those purposes into the early-1980s. In recent decades, however, the reporting system increasingly succumbed to pressures from miscreant politicians, who were and are intent upon stealing income from social security recipients, without ever taking the issue of reduced entitlement payments before the public or Congress for approval."

My hero, Milton Friedman
In reality, we've had an "inflation" problem for years and it has been triggered, as always, by easy monetary policy. When I served on the President's Advisory Panel on Federal Tax Reform in 2005, I had the great pleasure of meeting the late, great economist Milton Friedman. One of Friedman's claims to fame was his observation that inflation is always a monetary phenomenon: When you increase the amount of money in circulation, all else equal, prices are going to rise.

For the bulk of the past decade, rising prices were largely in assets: When we were experiencing "inflation" in stocks and home prices, we were happy participants, but now that inflation is directly hitting our pocketbooks, we are less sanguine. We are now suffering from what many feel were the irresponsible policies of former Federal Reserve Chairman Alan Greenspan, carried forward by the recent easy monetary policy of the Fed under current chairman Ben Bernanke. In the Greenspan era, bubbles in stocks and real estate were pumped up … today it's oil and other commodity prices. But this bubble is inflicting its damage as it's inflating—the other two wreaked their havoc as they deflated.

Oil = bubble redux?
The $17 spike in oil prices over two days (June 5 and 6) to nearly $140 per barrel was the largest two-day move ever and certainly can't be fully explained by supply/demand fundamentals or geopolitical risks. The energy futures market has become increasingly liquid but remains far too small to absorb the huge sums of global capital that are being wagered on oil price movements. Congress is certainly having a field day investigating speculation's impact, though as is their custom, they're more hesitant to place any blame on themselves.

I remain convinced that speculation is having a big impact on energy prices, at least at the margin. At the end of 2003, there was $13 billion in commodity index funds. By March of this year, that amount had grown 20 times, to $260 billion, and the momentum has been building—demand grew by more than $1 billion per day in this year's first quarter.

Signs of bubble-like conditions are getting more numerous by the day, suggesting that a major crack in oil prices could come at some point. The list includes, but is not limited to:

Congressional hearings on oil speculation.
Bernanke's comments on the dollar (more to follow on that).
Airlines and autos getting creamed.
Non-stop media coverage of the "energy crisis."
Gasoline subsidies being lifted or limited in Asia and India.
U.S. Strategic Petroleum Reserve additions halted.
Wall Street analysts' aggressive upside oil price targets.
Record decline in U.S. vehicle miles driven while SUV sales implode.
U.S. consumption of oil/oil products down nearly 4% in the first quarter.
Iranian "very large crude carriers" (VLCCs) holding 28 million barrels of oil in Persian Gulf on speculation of higher prices (and/or no buyers).
Demand destruction kicks in
We are also hitting an interesting threshold in global demand. As you can see in the "Oil expenditures hit 1980s 'breaking point'" chart, world expenditures on oil as a percentage of GDP are now at a level consistent with the "breaking point" in 1980, following which we experienced a decade-long decline in expenditures on oil and a 75% drop in oil prices. What we don't know, of course, is whether the new threshold is higher this time.

Oil expenditures hit 1980's "breaking point"

Annual average 1971-2007 with 2008 estimate assuming $118 oil price. As of December 31, 2007. Source: ISI Group.

None of our expressions about a potential blow-off phase for oil prices, or speculation's growing role as a price-setter, are meant to ignore the powerful forces of demand and supply. Unlike the 1970s, when we faced a supply shock, today's spike in oil prices is more about a demand surge, but it has come in the face of extremely tight supplies and limited new production.

Demand vs. supply shock
Economic theory holds that the effect of oil prices on the economy depends on the fundamentals of supply and demand. If prices ascend due to changes in supply conditions, the impact is depressed economic activity as energy becomes more expensive. But, if demand is the culprit, it leads to both a positive and negative effect. The positive effect is the purchase of U.S. goods and services by the growing emerging economies that drive demand.

That explains why oil's impact on our overall economy has been relatively muted—there are some offsetting positives (stronger exports to oil-rich and other fast-growth emerging economies) to the clear negatives. This has kept economic indicators like industrial production (one of the key determinants of recessions) in positive territory.

Has the Fed paved a road to 1970s-style stagflation?
I have regularly expressed my concerns about easy U.S. monetary policy, wondering whether we would have been better served if Bernanke & Co. had taken a different approach beginning last September (i.e., providing liquidity via their more creative facilities without cutting rates so drastically). The Fed's goal was to forestall a recession, but in doing so ignored the dollar (or implicitly fostered its weakness). At the same time, Congress unleashed the stimulus plan that has yet to have much impact on the economy (especially given that oil's rise has more than offset the value of the rebate checks).

Bernanke continues to reject comparisons to the 1970s, believing the U.S. economy's flexibility and resiliency will prevent the pass-through of commodity prices into a broader inflation problem. But the man who knows more about the dark days of the 1970s than most, former Fed chairman Paul Volcker, has other thoughts. He has said publicly that the Fed's explanations for today's policies echo those used to support easy money in the early '70s—with disastrous results—and that deeds, not words, are what's needed to protect the dollar. Remember, Volcker had to administer the foul medicine of higher rates and allow two back-to-back recessions in the early 1980s to fight inflation's nasty disease.

Rhetorical or actual inflation fighters?
It does appear that the Fed is now in pause mode, and the dollar enjoyed a brief respite as global interest rate differentials (the spread between yields here and overseas) stopped widening. The Fed may be trying to appear as inflation fighters, simply by not lowering rates any further. The Fed regularly talks about "inflation expectations," but this begs the question whether the central bank is more interested in fighting perceptions of the problem, rather than the problem itself.

Bernanke did break precedent recently when he, rather than Treasury Secretary Hank Paulson, commented on the dollar, saying the Fed was "…attentive to the implications of changes in the value of the dollar for inflation and inflation expectations and will continue to formulate policy to guard against risks to both parts of our dual mandate, including the risk of an erosion in longer-term inflation expectations." Those comments suggested, for the first time this cycle, that policy could go either way and rate hikes can't be ruled out.

Stopping inflation in its tracks isn't easy
Unique forces in the past 10 to 15 years have allowed for relatively loose monetary policy without runaway inflation—notably globalization and its attendant competition, which restrained prices. Now, we risk moving in the opposite direction. Just as it was difficult to cause inflation while globalized markets were keeping prices low, it's even more difficult to stop inflation when globalized markets are increasing prices.

The United States is a net importer; hence our large trade deficit. As our trading partners react to their own inflation problems, they have the economic growth and wage pressures to back up price increases, and they are now exporting inflation to our shores. The Fed can (and has) lowered rates to boost our economy, but in doing so, has only fanned inflation's fire more.

The next phase in this cycle may be one in which the Fed is forced to back up its rhetoric with real action. If the dollar sinks much further and/or oil and other commodity prices continue to surge, the Fed may be forced to raise rates regardless of the economic implications.

But all is not lost perhaps. A silver lining could be found in how we react as a nation. In the 1970s, conservation was seen as the primary long-term solution to that era's energy crisis. Today, we are thinking more comprehensively, embracing increased investment in alternative energy and better oilfield technology, along with conservation. Even today's most famous Texas oil man, T. Boone Pickens, is getting in the act—he's planning to build a $10 billion wind farm, the world's biggest yet. And that's not just hot air.


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