I want to follow-up on my last comment on the "W" recovery because it is absolutely critical for policymakers and investors to understand the arguments on both sides of the inflation/ deflation debate. I will make this post considerably shorter than the previous one, but there is plenty to cover.
First, we begin by looking at the latest quarterly review by Van R. Hoisington and Lacy H. Hunt of Hoisington Investment Management.
[Note: Click here to view all previous comments and here for a profile of Hoisington Investment Management.]
Hoisington Investment Management offers one of the best quarterly economic reviews on the internet. Their latest quarterly comment focuses on inflation/ deflation. They begin by stating:
Over the next decade, the critical element in any investment portfolio will be the correct call regarding inflation or its antipode, deflation. Despite near term deflation risks, the overwhelming consensus view is that “sooner or later” inflation will inevitably return, probably with great momentum.Does this get your attention? It certainly got mine. Let's read on:
This inflationist view of the world seems to rely on two general propositions. First, the unprecedented increases in the Fed’s balance sheet are, by definition, inflationary. The Fed has to print money to restore health to the economy, but ultimately this process will result in a substantially higher general price level. Second, an unparalleled surge in federal government spending and massive deficits will stimulate economic activity. This will serve to reinforce the reflationary efforts of the Fed and lead to inflation.
These propositions are intuitively attractive. However, they are beguiling and do not stand the test of history or economic theory. As a consequence, betting on inflation as a portfolio strategy will be as bad a bet in the next decade as it has been over the disinflationary period of the past twenty years when Treasury bonds produced a higher total return than common stocks. This is a reminder that both stock and Treasury bond returns are sensitive to inflation, albeit with inverse results.
..., let’s assume for the moment that inflation rises immediately. With unemployment widespread, wages would seriously lag inflation. Thus, real household income would decline and truncate any potential gain in consumer spending.And on the record expansion of the Fed's balance sheet:
Inflation will not commence until the Aggregate Demand (AD) Curve shifts outward sufficiently to reach the part of the Aggregate Supply (AS) curve that is upward sloping. The AS curve is perfectly elastic or horizontal when substantial excess capacity exists. Excess capacity causes firms to cut staff, wages and other costs. Since wage and benefit costs comprise about 70% of the cost of production, the AS curve will shift outward, meaning that prices will be lower at every level of AD.
Therefore, multiple outward shifts in the Aggregate Demand curve will be required before the economy encounters an upward sloping Aggregate Supply Curve thus creating higher price levels. In our opinion such a process will take well over a decade.
In the past year, the Fed’s balance sheet, as measured by the monetary base, has nearly doubled from $826 billion last March to $1.64 trillion, and potentially larger increases are indicated for the future. The increases already posted are far above the range of historical experience. Many observers believe that this is the equivalent to printing money, and that it is only a matter of time until significant inflation erupts. They recall Milton Friedman’s famous quote that “inflation is always and everywhere a monetary phenomenon.”On the surge of M2, Hoisington and Hunt write:
[Note: On that last point, read Alan Meltzer's New York Times op-ed article, Inflation Nation.]
These gigantic increases in the monetary base (or the Fed’s balance sheet) and M2, however, have not led to the creation of fresh credit or economic growth. The reason is that M2 is not determined by the monetary base alone, and GDP is not solely determined by M2. M2 is also determined by factors the Fed does not control. These include the public’s preference for checking accounts versus their preference for holding currency or time and saving deposits and the bank’s needs for excess reserves.
These factors, beyond the Fed’s control, determine what is known as the money multiplier. M2 is equal to the base times the money multiplier. Over the past year total reserves, now 50% of the monetary base, increased by about $736 billion, but excess reserves went up by nearly as much, or about $722 billion, causing the money multiplier to fall.
Thus, only $14 billion, or a paltry 1.9% of the massive increase of total reserves, was available to make loans and investments. Not surprisingly, from December to March, bank loans fell 5.4% annualized. Moreover, in the three months ended March, bank credit plus commercial paper posted a record decline.
M2 has increased by over a 14% annual rate over the past six months, which is in the vicinity of past record growth rates. Liquidity creation or destruction, in the broadest sense, has two components. The first is influenced by the Fed and its allies in the banking system, and the second is outside the banking system in what is often referred to as the shadow banking system.Hoisington and Hunt then discuss how massive increases in government debt will weaken the private economy,"thereby hindering rather than speeding the recovery."
The equation of exchange (GDP equals M2 multiplied by the velocity of money or V) captures this relationship. The statement that all the Fed has to do is print money in order to restore prosperity is not substantiated by history or theory. An increase in the stock of money will only lead to a higher GDP if V, or velocity, is stable. V should be thought of conceptually rather than mechanically. If the stock of money is $1 trillion and total spending is $2 trillion, then V is 2. If spending rises to $3 trillion and M2 is unchanged, velocity then jumps to 3.
While V cannot be observed without utilizing GDP and M, this does not mean that the properties of V cannot be understood and analyzed. The historical record indicates that V may be likened to a symbiotic relationship of two variables. One is financial innovation and the other is the degree of leverage in the economy. Financial innovation and greater leverage go hand in hand, and during those times velocity is generally above its long-term average of 1.67 (Chart 4, above, click to enlarge).
Velocity was generally below this average when there was a reversal of failed financial innovation and deleveraging occurred. When innovation and increased leveraging transpired early in the 20th century, velocity was generally above the long term average. After 1928 velocity collapsed, and remained below the average until the early 1950s as the economy deleveraged.
From the early 1950s through 1980 velocity was relatively stable and never far from 1.67 since leverage was generally stable in an environment of tight financial regulation. Since 1980, velocity was well above 1.67, reflecting rapid financial innovation and substantially greater leverage. With those innovations having failed miserably, and with the burdensome side of leverage (i.e. falling asset prices and income streams, but debt remaining) so apparent, velocity is likely to fall well below 1.67 in the years to come, compared with a still high 1.77 in the fourth quarter of 2008.
Thus, as the shadow banking system continues to collapse, velocity should move well below its mean, greatly impairing the efficacy of monetary policy. This means that M2 growth will not necessarily be transferred into higher GDP. For example, in Q4 of 2008 annualized GDP fell 5.8% while M2 expanded by 15.7%. The same pattern appears likely in Q1 of this year
The highly ingenious monetary policy devices developed by the Bernanke Fed may prevent the calamitous events associated with the debt deflation of the Great Depression, but they do not restore the economy to health quickly or easily. The problem for the Fed is that it does not control velocity or the money created outside the banking system.
Washington policy makers are now moving to increase regulation of the banks and nonbank entities as well. This is seen as necessary as a result of the excessive and unwise innovations of the past ten or more years. Thus, the lesson of history offers a perverse twist to the conventional wisdom. Regulation should be the tightest when leverage is increasing rapidly, but lax in the face of deleveraging.
They end their quarterly review by stating that bonds still offer exceptional value:
Since the 1870s, three extended deflations have occurred--two in the U.S. from 1874-94 and from 1928 to 1941, and one in Japan from 1988 to 2008. All these deflations occurred in the aftermath of an extended period of “extreme over indebtedness,” a term originally used by Irving Fisher in his famous 1933 article, “The Debt-Deflation Theory of Great Depressions.”
Fisher argued that debt deflation controlled all, or nearly all, other economic variables. Although not mentioned by Fisher, the historical record indicates that the risk premium (the difference between the total return on stocks and Treasury bonds) is also apparently controlled by such circumstances. Since 1802, U.S. stocks returned 2.5% per annum more than Treasury bonds, but in deflations the risk premium was negative.
In the U.S. from 1874-94 and 1928-41, Treasury bonds returned 0.9% and 7% per annum, respectively, more than common stocks. In Japan’s recession from 1988-2008, Treasury bond returns exceeded those on common stocks by an even greater 8.4%. Thus, historically, risk taking has not been rewarded in deflation. The premier investment asset has been the long government bond (Table 1, below, click to enlarge).
This table also speaks to the impact of massive government deficit spending on stock and bond returns. In the U.S. from 1874-94, no significant fiscal policy response occurred. The negative consequences of the extreme over indebtedness were allowed to simply burn out over time. Discretionary monetary policy did not exist then since the U.S. was on the Gold Standard.
The risk premium was not nearly as negative in the late 19th century as it was in the U.S. from 1928-41 and in Japan from 1988-2008 when the government debt to GDP ratio more than tripled in both cases. In the U.S. 1874-94, at least stocks had a positive return of 4.4%. In the U.S. 1928-41 and in Japan in the past twenty years, stocks posted compound annual returns of negative 2.4% and 2.3%, respectively.
Therefore on a historical basis, U.S. Treasury bonds should maintain its position as the premier asset class as the U.S. economy struggles with declining asset prices, overindebtedness, declining income flows and slow growth.
Finally, the Financial Times' view of the day asks, Is Inflation inevitable?:
There is a growing belief in financial markets that uncontrollable inflation is inevitable, but that view is wrong, argues Dominic Konstam, interest rate strategist at Credit Suisse.
Nor are we heading towards a prolonged depression and deflation, he believes.
“A more plausible scenario is a mildly deflationary middle way with positive nominal growth. We can think of this as Grandma Goldilocks,” he says.
This is a reference to the late 1990s, when market conditions were deemed just right – not too hot and not too cold – because real growth was high, but inflation low. “A decade later, Goldilocks may not be quite dead but just a lot older,” he says.
Mr Konstam believes growth is likely to be relatively subdued in the next few years, driven by fiscal stimulus, while real interest rates will remain high. He believes consumers will be spending less and saving more, exerting significant downside pressure on inflation. There will be plenty of excess capacity in the economy. “The output gap is very large and forewarns of downward pressure on prices to come,” he says.
What does this mean for financial markets? “If we’re right, [10-year Treasury] bond yields aren’t going to zero, but they’re going to stay low for a while. We’re not going to 4 per cent anytime soon. Stocks may not make new lows and they will surely be capped to the upside.”
What will be the end result? Think about it as two huge tidal waves headed for each other. They might cancel each other out, but chances are that one will dominate the other and after reading Hoisington's quarterly review, I have an eerie feeling deflation will swamp inflation.
If deflation does prevail, that spells trouble for pension funds that are heavily exposed to stocks and inflation-sensitive assets. They undertook a giant experiment that will likely end up costing future generations.
After reading this comment, do you still believe there is a bubble in bonds?