The Inflationary Fever Is About to Break
By RANDALL W. FORSYTH
While producer prices rise the most in 27 years, deflation poses the danger ahead.
YOU MAY NOT NOTICE IT during the dog days of August, but the days are getting shorter. The bigwigs are at the beaches and shirts stick to the backs of the rest of us stuck in the steamy city. But, almost imperceptibly, the sunset is coming earlier and earlier, just as summer is at its ripest.
Indeed, the days have been getting shorter ever since the Summer Solstice. That is the longest day of the year, which necessarily means days can only get shorter. At the apogee, the heights are most striking -- even though it's all downhill from there.
And so it is with the producer price index, which saw its biggest jump in 27 months last month. Wholesale prices of finished goods rose 1.2% in July, putting them 9.8% higher than a year earlier, the biggest annual increase since June 1981. Just as that was close to the point that the inflationary fever broke, so it is now.
To repeat a point made here last week, the government's numbers on inflation are old news ("Gold Takes the Prize in the Inflation Olympics," Aug. 15.) Even as the consumer price index registered a 5.6% jump in the year to July, the most since 1991, the markets are signaling something entirely different.
That's also the view of Richard Russell, the publisher of the "Dow Theory Letters" for a half century. Of the headlines of the fastest pace for inflation in 17 years, Russell writes: "Forget it, this is history -- this is not what's happening in the market."
"From what I see, the markets are telling us to prepare for hard times, and a global spate of the worst deflation to be seen in generations. This is why gold has been sinking, this is why stocks have been falling -- big money, sophisticated money, is cashing out, raising cash, preparing for world deflation," Russell writes.
That is a forward-looking view from the peak, from which the only way is down. But for those who extrapolate the past into the future, it's easier to see higher highs. Or continual long, hot days as the summer stretches on -- even as September draws ever closer.
The current inflationary fix in which we find ourselves is the result of past Federal Reserve policies that remained too easy for too long. To fight the chimera of deflation early in the decade, the Fed drove the federal funds rate down to 1% and then began raising it at a glacial pace. That cheaper-than-free money drove up commodity prices and fueled the credit bubble that brought upon the current crisis.
The markets now are sounding the sirens that the reverse is happening. Money is going from promiscuously loose to excruciatingly tight. That is most evident in the fall in the price of gold and the scramble for dollar liquidity, which is lifting its exchange rate off the floor.
The symptoms of this squeeze also are visible in the commodity and bond markets. Commodities, from crude oil to corn, from silver to soybeans, are down after having been bid up to the moon -- where demand no longer could sustain elevated prices.
In the bond market, in the face of soaring CPI and PPI reports, Treasury yields are lower, back down to the level of mid-July. That was when a flight to quality over worries about Fannie Mae and Freddie Mac precipitated the government's issuance of a blank-check backing for the mortgage giants' senior debt and mortgage backed securites. Even if the government fudges the official inflation numbers, as many suspect, the bondos aren't fooled; they're looking ahead to the lower price trends ahead.
For one thing, the horrific producer price rises are not being pushed through to the consumer. According to Stephanie Pomboy's MacroMavens' roundup, the shortfall of wholesale prices relative to retail prices is the biggest since the early 1970s when wage-and-price controls were imposed. That suggests the price surge is hitting companies' profit margins. Still, in the U.S. at least, consumers aren't able to push for higher wages on the basis of rising prices, so they also feel the pinch.
All of which are symptoms, not causes, of the deflationary riptide dragging at the U.S.economy. Inflation is always and everywhere a monetary phenomenon, Milton Friedman taught. And the monetary tides have decisively turned.
Broad money and credit growth have rapidly weakened, according to Gabriel Stein of London-based Lombard Street Research. That reflects the contractionary phase of the credit cycle that is now playing out.
The broad money supply, known as M3, no longer is published by the Fed but still is tracked and estimated by some private economists. LSR and other economics groups interpolate the monetary measure from various published data.
And these numbers corroborate the anecdotal evidence -- that credit has gotten far tighter in recent months. And if those trends persists, the monetary tinder to fuel inflation just won't be there.
LSR finds a sharp drop-off in broad money in July, a $50 billion plunge, the biggest monthly drop since data began in 1959. One month does not make a trend, but LSR calculates the three-month growth rate is just 2.1%, well below the six-month rate of 6.3% and the 12-month rate of 11.5%. All of which show broad money growth is decelerating rapidly.
"The cause of weaker broad money growth is not difficult to find. The growth of credit is also slowing sharply," Stein writes. Bank credit grew at a 2.8% annual growth rate in the six months ended in July, the slowest pace in six years and a far cry from the double-digit growth rates seen from September 2007 to March 2008. During that period, corporations rushed to draw on credit lines before banks turned off the tap. "By its very nature, this could be only a temporary development," he points out.
This transition from credit bubble to credit bust exerts a powerful deflationary undertow on the economy. The current high inflation readings are the result of past inflationary policies; the tide in those policies has clearly turned. This sea change won't be visible for some time.
But a decline in inflation won't sound an all-clear for the economy and the markets. The deflation is the result of the contractionary forces now in place. And notwithstanding the speeches of central bankers, in which they pay pious attention to the inflation numbers, they may be forced to focus their attention on deflation.
"To be sure, all G7 central banks are worried about the temporary rise in headline inflation, and all are threatening to hike interest rates," writes Nouriel Roubini, the New York University professor who's gotten the economic picture right more than anybody else, on RealClearMarkets.com.
"Nevertheless the risk of a severe recession and of a serious banking and financial crisis will ultimately force all G7 central banks to cut rates. The problem is that, especially outside the U.S., this monetary loosening will occur when the G7 and global recession become entrenched.
"Thus, the policy response will be too little, and will come too late, to prevent it," Roubini concludes.
Of these deflationary trends, Richard Russell writes: "I just finished reading the New York Times, Los Angeles Times and Barron's and there isn't a hint of what I'm writing about in any of these publications."
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