Mile High Insights

Is Worldwide Inflation Caused by the Fed?

06/30/08

I had hoped that the January low in the broad market would hold after being tested successfully in March. While it may still hold, the chances of this happening are diminishing. The Dow Jones already made a new low. The Russell 2000 and the NASDAQ are still holding well above those levels. The Fed had opened the floodgates in March and usually the market responds well to aggressive easing. This time, however, it seems that inflation concerns are complicating the picture. Inflation is the big scare on Wall Street because it causes fixed income instruments to go down in price (up in yield) and then leads to lower Price-Earnings multiples. Multiple contraction reflects diminishing expectations and/or increased competition from other investments and will always be more powerful than company fundamentals. So here we are again, looking at inflation as the main culprit for everything, just like 3 months ago. Not only that, growth almost everywhere around the world is slowing, too. The reasons for slowing growth are well known: de-leveraging in the financial sector, overextended consumers needing to tighten their belts, transfers of wealth from oil consuming nations to oil producing nations through high oil prices etc. etc. While the markets are now being squeezed from slowing growth and rising inflation, the inflation portion seems less understood and more ambiguous than the growth question. When we speak about inflation today, we mainly refer to food and energy (commodity) inflation as opposed to wage inflation. Most people lay the blame for commodity inflation at the doorstep of the U.S. treasury. The dollar seems to have become the world's main problem: its fall in value supposedly causing the spike in commodity prices, which in turn triggered a sharp upturn in inflation rates all around the world, but especially in the emerging markets (where food and energy represent a much bigger piece of the average family's spending than in most OECD countries). It is true that the dollar is still the world's main transactional currency (whereas the Euro is more the safe investment currency) no matter whether you want to buy coal in Brazil, flat screen TVs in Korea or coffee in Africa, you will have to have access to U.S. dollars. But Milton Friedman said that "Inflation is always and everywhere a monetary phenomenon." and the Cleveland Fed defines inflation as "...a rise in the general level of prices caused by excessive money creation..." So it seems that some very smart people have postulated that it takes excess money (not only rising oil prices) to cause inflation. The fixed income markets have the biggest stake in the inflation game. Take a look.

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Inflation as expressed by the consumer price index (first chart) is hovering around 4% at the moment. This includes food and energy. The real (inflation adjusted) yield for 10-year treasury notes (second chart) is currently approaching zero for an investor's pain and risk exposure. Why do U.S. bond traders let this happen and continue to buy (and not only sell) 10-year treasury notes? Because they also assume that inflation, no matter how it is expressed, will moderate in the future. They also know that the Federal Reserve has not really created that much money to justify exploding inflation. M1 for example actually shrunk over the last 6 months; other cash measures such as the monetary base grew by 1%. M2 has grown about 6% over the past year while MZM has grown by 16%. I suspect that the old M3 measure would have grown by a similar percentage. The question now is, which one of the "M's" is the true inflation driver? It seems to me that the most likely candidate is the one with the highest growth rate. Who is driving MZM and M3 then? All the banks subject to fractional reserve-banking and private money pools, the institutions that PIMCO called the shadow banking system. They have been driving MZM and M3, not alone and not single handedly, but they helped. The other parties involved in boosting the broad money measures and thus driving international inflation are the international banks. They are also subject to their own national fractional reserve banking regulations and they can therefore create money out of thin air, too. They can hold Euro-Dollars and lend a multiple of those deposits to creditors. Creditors have been eager to take out loans in U.S. dollars because they required low interest rates and chances were that the currency would decline and thus shrink the principal to be repaid at a future date. If a bank in Europe or Asia takes in $1 Million in Eurodollars, the amount it can lend out is probably $10 Million. Eurodollars do not increase the money supply in the US, but after conversion increase the money supply in another country. There you have, simplified but in a nutshell, the bulk of today's inflation problem. Now let us jump to a concept which I can not prove to you but which nevertheless appears eminently logical to me. I received another "outside the box" newsletter from John Mauldin the other day, and this one came from GaveKal. Their work is first class and they brought a strange causality (or is it coincidence?) to my attention. They found a link between the U.S. current account deficit and international blow-ups. In the following paragraphs I essentially try to explain their idea as I understand it. Look at the charts.

We established above that the U.S. dollar is still the transactional currency of choice worldwide. We also established that U.S. dollar loans were taken out by many international entrepreneurs and corporations. Think of the current account as a gas tank that fills up or empties out into - and thus provides working capital to - the world economy. If the U.S. runs a current account deficit, the world enjoys plenty of liquidity and business is good thanks to the gas tank pumping fuel into the world economy. If the U.S. current account turns positive, however, it sucks cash out of the world economy (remember the fractional reserve banking with a factor of 10:1) and delevering the world by a factor of 10. So in essence, the current account deficit has always been the mechanism through which the United States could reflate or deflate the global economy. When the US current account deficit improved, the US deflated other countries and vice versa. This is why, whenever we see an improvement in the US current account deficit, somebody somewhere goes bust. The first chart above shows you the quarterly change in $ Billions from the previous year. The current account deficit for the first quarter 2008, for example, amounted to $176.38 Billion. This was $20.554 Billion less than the current account deficit from the first quarter of 2007. Therefore the current account improved by $20 Billion and probably made $200 Billion less available to the world economy. It now also makes sense that the U.S. can have 4% inflation while more than 50 countries have inflation running at 10% or higher. Those are probably the countries that have their currencies pegged to the dollar. Here is how GaveKal is explaining it:
"So what happens when a Chinese property developer, or a Vietnamese industrialist, borrows US$ to finance his latest project? The first thing he does is that he changes the dollars he does not need for RMB, Rupee, Dong, etc... And, at this point, the foreign central bank has three choices:

1- It can allow its currency to rise. This is what Brazil, South Korea... have done in recent years.
2- It can print money to prevent its currency from rising and then sterilize its FX intervention.
3- It can print money to prevent its currency from rising and just accept the consequences of fast money supply growth (usually higher inflation and asset prices).

And by and large, this is what most nations on the other side of the US current account deficit (i.e.: Asia and OPEC) have done. And unsurprisingly, these are the countries that are today dealing with the largest inflation threats. We would thus argue that the US current account deficit has been a double inflationary force for the world at large. First, the US current account deficit has pushed a number of countries towards reflation, and secondly, the large US current account deficit has helped propagate the belief that the US$ could only fall, and thus encouraged large borrowings of US$ outside of the US. And the US current account deficit, combined with the willingness to borrow US$, has been an inflationary force for more than just Asia and the Middle East. It may also explain the surge in money growth in Europe!"

Mr. Gave then brings his idea to the logical conclusion. The second chart above shows the current account deficit divided into deficits with oil producing countries and deficits with non-oil producing countries. Two years ago the U.S. maintained two thirds of its deficit with non-oil producing countries and one third with oil-producers. Today this relationship is reversed. One could argue that while the oil producing nations are still being reflated, the non-oil producing nations (the weakest links in the chain) are already deflating and hurting to the point that they may no longer be able to import and pay for all the oil they need. Once this state of affairs becomes common knowledge, oil prices are going to weaken. The U.S. deficit has already improved over the past two years by about $150 Billion. If oil should roll over then the oil-producing countries would have to suffer the fate that non-oil producing countries are suffering right now. Deleveraging and less liquidity leading to a global slowdown. In this case the U.S. market might even be the best performing stock market in 2009, benefiting from an improving current account deficit, capital flowing back into the U.S. scooping up cheap assets and stocks in rally mode.

Hermann Vohs

Hermann Vohs is president of Cales Investments, Inc., a registered Broker-Dealer. All material presented herein is believed to be reliable but we cannot attest to its accuracy. Investment recommendations may change and readers are urged to check with their investment counselors before making any investment decisions. Opinions expressed in these reports may change without prior notice. Hermann Vohs and/or the staff at Cales Investments, inc. may or may not have investments in any of the markets cited above. Hermann Vohs can be reached at 303-765-5600.

This information is not to be construed as an offer to sell or the solicitation of an offer to buy any securities.