The Elephant in the Room: Why Inflation Is Not Dead
Bond and commodity markets are currently worrying about the wrong thing
If we’ve learned anything from the ten-plus years of successively popping asset bubbles, it is that John Maynard Keynes was right when he said markets are able to stay irrational longer than most of us can remain solvent. And despite protests to the contrary by generations of investors, there are always very good reasons why markets do what they do – we just don’t always understand them at the moment. Indeed, as an individual, the investor or analyst may be brilliant, but as a group they often do things that defy common sense, imagination, or both.
Bond trading over the past several weeks has been a prime example of such irrationality. Like the dotcom and real-estate bubbles before it, the prices for U.S. Treasury bonds have reached truly absurd proportions. Yet in their emotional rush to protect principal at all costs, bond investors are forgetting the impact of the single largest determinant of long-term fixed-income return: Inflation.
Several issues ago, we profiled the extraordinary price rises underway in things like corn, wheat, cotton, sugar, cocoa, rice, oil and even lumber. In fact, earlier this year some inflation measures were posting the highest figures in three years, and it seemed likely that the Fed’s decision to print our way out of the economic crises was coming home to roost. Fast forward to this fall, and the rapid deterioration of both the U.S. and European debt situations, coupled with slowing growth in emerging markets, brought the fear of renewed recession to the fore.
Accordingly, after having been dismissed as a risk during the 2008 crisis, deflation, not inflation, is back as the chief concern. This has played havoc with commodity prices since our last issue. Yet crucially, virtually all major commodities remain elevated from year-ago levels, even if they have come off their mid-summer highs, and the prices paid at the grocery store are still rising.
In the meantime, the Federal Reserve continues to loosen the purse strings. While the $400 billion “twist” operation does not technically extend the Fed’s bloated balance sheet (since the Fed is selling shorter-term paper in favor of longer maturities), its commitment to buy mortgage-backed securities does. Something on the order of $2 trillion (including QEs I and II, bailouts, etc.) has been pumped into the economic system since the end of the financial crisis. And that is just in the U.S. While the European Central Bank, true to form, is a bit behind on its quantitative easing experiment, it’s not above easy money policies as well.
It is from here that the unintended consequences of the last few years will be seen first – while the Fed may well be wishing for a little inflation these days, it should be very careful. History has shown that inflation is the economic equivalent of the genie in the bottle – easy to let out, but extremely difficult to control once free.
As we went to press, bonds continued to price Armageddon in the form of a deflationary spiral wrought by the balance sheet depression underway in the developed world. Equity investors have hit the sidelines en masse, with over $2.6 trillion sitting in money market funds earning the grand total of 0.02% per year. At the same time, gold has been busily pricing the inflationary impact of the most extraordinary surge in monetary liquidity in generations. The relatively minor correction in the early fall notwithstanding, gold’s trading tells us that there is an elephant in the room being ignored by bond and equity investors alike.
We think gold is right. When growth does pick up, as it most certainly will at some point, all those dollars sloshing around the system will mean the Fed is behind the power curve of monetary policy almost immediately. Moreover, real inflation is understated in every statistic you hear. Why? Because it doest not include real estate.
It turns out that housing costs – which include rent and are termed “shelter” by the BLS – make up a whopping 42% of the overall headline CPI measurement. Weak housing for the last several years effectively suppressed overall consumer inflation statistics. Indeed, if you strip shelter out of the CPI numbers, it turns out that the prices of the other 58% of the calculation have been rising nearly twice as fast as reported. This “everything else but housing” inflation rate is running at a 4.7% annual rate, driven by increases in energy and other commodity prices. At the moment, inflation is off the radar, but it will not take much of a recovery in housing – which has clearly begun to stabilize – to put it squarely front and center again.