Inflation On The Horizon?
12/15/09
Investors continued for the 38th week in succession to put more money into bond funds than into stock funds. Risk aversion is still palpable all around. It is unbelievable. 10 months and 60% later, the public is still too afraid to touch stocks with a ten foot pole. The latest rationalization of why you should stay away from stocks is this: "The Fed about to withdraw liquidity because of data that turned out stronger than expected and because of incipient inflation." Stronger than expected data is what everybody was hoping for, yet everybody also frets over the consequences that strong data eventually means withdrawal of emergency liquidity measures. It is therefore no wonder that everybody stares at today's Fed meeting as if Bernanke was a poisonous snake, who can kill you with one single stroke (or poisonous sentence). Today's higher than expected PPI number gave the bears even more ammunition. Inflation, according to the report, seems to be on the rise again, or so their story goes. I do not want to discuss the inflationary threat today. Suffice it to say that inflation is contained as long as banks hoard money rather than lending it to consumers or businesses who might produce some actual demand for goods and services with it. The Federal Reserve's monetary creation therefore has thus far not led to inflation. Take a look.
The first chart shows the outstanding commercial and industrial loans at all commercial banks. The loan balance declined by $300 billion in 12 months. The total balance of outstanding loans declined from $1.65 Trillion in 2008 to $1.35 Trillion in 2009. They call this a credit crunch for a reason. The annual comparisons are still declining and so is the 6 month rate of change. The 3 months rate of change at least shows the first uptick since October 2008. Yes, things are this bad, if you want or need credit. Why are the banks not lending? Take any number of reasons. They were foolish in lending too freely which got them into trouble. They are too scared to lose even more money on deadbeat projects or creditors. The regulators want them to tighten their lending standards. There are no creditworthy borrowers left. ... and so on. Obama doesn't like it, Congress and the Senate don't like it, businesses and consumers don't like it ... and the banks don't like it either. So what is a halfway intelligent banker (no oxymoron) to do? He lend to the safest borrower in the world (Uncle Sam) and buys Treasury Notes and deposits his excess reserves with the Federal Reserve. The regulators should like that, right? No imprudent lending here, right? Yes, but everybody else still hates it and continues to call them names. The reserve balances that banks deposited with their respective Federal Reserve branch offices have exploded since the second half of September 2008. The funds are tier 1 capital and are almost encouraged by the regulators. That's the bad news. The good news is that we still have no inflation. The liquidity created by the Federal Reserve has not found its way into the economy yet. If banks should decide en masse to start lending again (and do they ever do anything not "en masse"?) watch for inflation to pop higher. So, to make a long story short, the two charts above can give us an early warning as to the timing of inflation. When C&I Loans increase and/or when reserve balances with the Federal Reserve decrease, that is the time when we need to be extra vigilant. That time however has not come yet. For this reason, I do not expect the Federal Reserve to surprise markets with unexpected statements today. Recent FOMC statements have come in three paragraphs. The first paragraph is a review of recent data. Here the Fed is likely to repeat what it noted last month, namely that "economic activity has continued to pick up." This comes on the heels, of course, of a series of data that is encouraging Street economists to raise fourth-quarter GDP forecasts, including inventory, trade, retail sales and the smallest job loss of the year. The second paragraph deals with the Fed's assessment of inflation and is unlikely to change. Slack resource utilization (labor market and industrial capacity utilization rates) will dampen price pressures. Inflation expectations are stable. The third paragraph is generally the policy guidance. This section is also unlikely to change substantively. The Fed is likely to maintain that these economic conditions are "likely to warrant exceptionally low levels of federal funds rate for an extended period." The completion of its agency and agency mortgage-backed securities purchases can be expected at the end of the first quarter of 2010. If there are no surprises, the market should not show any dramatic reaction to the Fed's statement. This includes stocks, bonds and the dollar, whose firmer tone since the unemployment numbers came out two weeks ago, has been much firmer and put some honesty back into the carry traders of this world. Nevertheless, hyperactive media experts have already concluded, that removal of liquidity measures and rising interest rates at the short end through higher Fed Funds targets and at the long end through bond market vigilantes demanding compensation for inflation risk, is a foregone conclusion. Nothing could be further from the truth! Look at the first chart below.
The first chart above shows the velocity of money. Velocity is the ratio of GDP to the money supply, or how many times a dollar turns through the economy during the course of a year. In the example above I simply divided nominal GDP by M2 for each quarter to arrive at the above chart. You see that the turnover speed of each dollar in the economy reached its peak during the highs of the internet boom in the late nineties and thereafter collapsed precipitously to the current level. Depending whether I take July, August or September M 2 data, I will receive a line that is still in full retreat or that starts to bottom out, as shown. This is the liquidity trap that accompanies a depression. The Federal Reserve is fighting this decline in velocity by providing ample liquidity to financial institutions and the economy through quantitative easing. Many people think that these measures are no longer necessary and that they will stoke inflation. The recent rise in bond yields seems to indicate the same. Bonds fell precipitously (and thus yields rose quite violently), when the unemployment numbers two weeks ago came in much better than expected. Rising rates along with higher growth prospects made the US more attractive compared to Europe. The accompanying short squeeze catapulted the dollar to new three months highs. The dollar gained most against the Euro and less against Asian currencies, but this seems to have been the result of Europe's internal problems. The brewing financial storm was initiated by Greece, then came Austria and now Ireland. Dollar strength results from Euro weakness not from changes in perception of the dollar landscape. That will come, but probably later in 2010. Right now, easy money policy favors the dollar carry trade a while longer.
Hermann Vohs
"High steel prices cause inflation like wet sidewalks cause rain."
Roger Blough, former Chairman of US Steel
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.
