Incipient Inflation

Sep 7th, 2009 by Joseph Y. Calhoun, III

“Inflation can be pursued only so long as the public still does not believe it will continue. Once the people generally realize that the inflation will be continued on and on and that the value of the monetary unit will decline more and more, then the fate of the money is sealed. Only the belief, that the inflation will come to a stop, maintains the value of the notes.”Ludwig von Mises, On the Manipulation of Money and Credit

Being an old fashioned sort, I view inflation purely in terms of the value of money. Once upon a time, inflation was defined as the production of money in excess of demand resulting in a loss of purchasing power. Deflation was defined as the production of money insufficient to meet demand. During the whirlwind of the crisis last fall, it seems fairly obvious that the second condition prevailed. The demand for dollars was so great and the supply so limited that the value of the dollar rose in the face of the crisis. From July of last year to its peak in March this year, the dollar index rose nearly 25%. Even measured against gold - the oldest form of money - from July to October, the dollar rose roughly 28%. So, by any accepted measure, deflation was dominant during the climax of the crisis.

The deflation appears to me to have ended in March, if not sooner. After peaking near 89 in early March, the dollar index has now fallen to 78 or roughly 12%. Gold responded even sooner; after falling to roughly $700 in November, gold is now threatening to break the $1000 barrier that has stood as resistance for almost two years. That’s a gain of 40%. If inflation is best defined by the value of money, it has been with us since at least March.

One is tempted to look at this series of events and conclude that while inflation may not be a great policy it certainly is preferable to the alternative that prevailed last fall. Certainly the finance ministers of the G-20 agree with that sentiment as they managed to meet over the weekend and accomplish nothing except to reaffirm their commitment to inflationary policies. The stimulus shall continue until morale improves.

Inflation, while successful at reviving economic activity in the short run, is not the answer to our long term problems. We have only just experienced the type of boom that inflation creates and while some may have felt good during the boom - realtors, bankers and construction firms come to mind - I think we can all agree now that the general welfare was not enhanced but rather severely degraded during the great real estate and commodity boom. Can a problem created by inflation possibly be solved by more inflation?

The inflation that seems to have started in March has mostly been evident in asset prices. Some economic statistics have improved, but there are some gaping holes in the recovery. The most obvious is the lack of job creation on which we received yet another dismal report Friday. August saw the loss of an additional 216,000 jobs and that was the good news. The unemployment rate rose to 9.7% and the household survey from which that figure is derived showed that the number of unemployed persons rose by 466,000. The stark difference may be a function of the source of the data. The household survey includes small businesses while the establishment survey is confined to larger concerns. It isn’t surprising - at least to me - that in an economy where large businesses are lavished with government largesse, small business is suffering more.

Another area that has yet to show any improvement is investment. In my view, a lot of our current problems can be traced to the lack of investment - outside of residential construction - in the period after the last recession. Rather than being invested in productive assets, the policies of the Fed and the Treasury diverted capital to real assets such as real estate and commodities. That a policy of suppressing interest rates and pursuing a cheaper currency proved to be so disastrous doesn’t seem to have penetrated the consciousness of our current policymakers.

The problems facing our economy cannot be papered over with more dollars and I think we may be rapidly approaching the point where the public finally catches on to the game as von Mises warned. If that happens, it will only make the recovery from the last inflationary episode more lengthy and difficult.

Weekly Economic and Market Review

As I said above, inflation will improve economic activity in the short run and the statistics released last week continued to reflect that. The ISM manufacturing survey finally moved above the 50 level that indicates expansion. The report showed improvement in almost all aspects, but in keeping with the inflation theme this week, I would point out the prices index managed to rise ten points even with all this slack in the economy that the Fed believes will keep inflation in check. The pending home sales index increased for the sixth straight month and construction spending, while down overall, showed an increase in the residential component. Productivity rose 6.6% in the second quarter which may be good news for corporate profits but not so good for all those people looking for a job. Factory orders rose in July, but the report was a mixed bag with orders ex-transportation falling. Jobless claims fell ever so slightly. The ISM non manufacturing survey rose but remains below the 50 level. And as discussed above, the payroll report showed losses of 216,000 jobs.

The US stock market rallied on Friday after the payroll report but still showed a loss of about 1% on the week. All the money managers who parade across CNBC daily pining for a September correction appear likely to remain frustrated. The Fed’s money creation efforts may not have much effect in the real economy, but the effect in markets is hard to ignore. It certainly seemed to have an effect on gold last week which jumped nearly $50/oz. Gold is now nearing the $1000 level again which has proved big resistance in the past. A close over that level may set off a stampede to buy.

If you’d like to receive this weekly update by email, click here.

Selected charts

Gold faces a major test at the 1000 level. I would not be surprised to see some kind of pullback before making another assault.

The S&P 500 neatly held to its trend line. While I am not positive about the long term prospects for the economy, the stock market responds to lots of short term factors which remain positive for now. From a fundamental perspective the rising productivity is good for earnings and next quarter should provide easy comparisons from last year.