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The Great Inflation Hoax
By Don Luskin
Special to TheStreet.com
8/29/00 2:37 PM ET
Every stage in the market cycle is dominated by a single story or theme, a dominant paradigm. When the paradigm changes, smart investors know it's time to move on to a new stage in the cycle. The paradigm is now changing, and the market is changing with it -- for the better.
The old paradigm was Fed-fear. The new paradigm is zero inflation. That's right, there is no inflation. And that's what's driving the breakouts in all the U.S. equity indices.
The truth is that there probably hasn't been any inflation all along. This year's Fed shock therapy on the economy and the stock market has been based on an illusion -- like the Emulex hoax carried out on a vast, market-wide scale. Too bad, because the economy's future performance has surely been compromised somewhat by the Fed's gratuitous rate hikes. But the patient is healthy -- it can probably survive a little unnecessary treatment for a disease it never had.
Most economists and financial journalists are still fretting over the slightly accelerating Consumer Price Index and red-hot gross domestic product growth, treating those as prima facie evidence of inflationary pressure and a continuing hawkish bias at the Fed. But I'd rather listen to the market. It's telling us something entirely different -- that there is no inflation, and that even the Fed might start getting it right this time.
One iconoclastic economist who has put together all the pieces of the new paradigm is David Gitlitz, president and chief economist at DG Capital Advisers -- and a member of the online think tank at MetaMarkets.com. Last week he circulated a paper to his blue-ribbon institutional clients called "The Zero Inflation Reality."
Gitlitz argues that "...robust growth [has] not heralded a rising price level. Mounting evidence strongly suggests that zero inflation is now a practical reality. What is currently registering as inflation in the official data is in fact a statistical illusion, to a significant degree reflecting the statisticians' inability to accurately measure those New Economy forces that have been key to the growth pickup in recent years."
For Gitlitz, the key insight is to understand what drives the GDP price deflator, which treats inflation as the difference between nominal and real output. That measurement requires accurate productivity figures across the economy, yet Gitlitz believes he has uncovered proof that service-sector productivity is severely mismeasured in the deflator -- in fact, Gitlitz believes that the Bureau of Economic Analysis assumes it to be negative. And if that's true, then inflation as measured by the GDP price deflator is zero or less!
Here's how Gitlitz figures it. It's complex, but it's well worth trying to follow.
The Bureau of Labor Statistics estimates that total nonfarm business productivity has grown at an average rate of about 2.5% on a four-quarter, moving-average basis over the past three years. At the same time, they show output per hour in manufacturing growing at 5% over the past three years. They don't explicitly publish productivity numbers for the service sector, which makes up 60% of nonfarm output. But if overall nonfarm productivity is only 2.5% when manufacturing productivity is 5%, then there's no escaping the conclusion that the Bureau of Labor Statistics assumes service-sector productivity to be negative, probably by an average of up to 1% year over year -- that's the only way to get 5% down to 2.5%.
Gitlitz is telling his clients, "Any reading of abundant anecdotal evidence, of course, suggests such an assumption is ludicrous. Had service businesses actually experienced declining productivity over this period, corporate profits would have been slumping rather than soaring, real wages would at best have remained stagnant, and job cuts widespread."
He's right. Service-sector productivity is growing thanks to technologies that vastly enhance the power to manipulate information -- the staple commodity of the service sector. How ironic that these technologies come from the very companies whose stocks have driven the "irrationally exuberant" market that the Fed so fears.
If we assume that service-sector productivity growth is at least as high as the average GDP price deflator rise of 1.6% over the last three years, then inflation is zero. Now, what if service sector productivity growth is running even higher, say 2.5-3.5%? Then we're looking not an inflation, but at deflation, at a rate of about 1-2%.
If Gitlitz is right, then all eyes should be on the Fed now to see how they respond. The last time the specter of deflation raised its ugly head, in the fall of 1998 following the Asian currency crisis and the Russian bond default, the Fed responded appropriately by swiftly lowering rates.
Fed Chairman Alan Greenspan at least may be beginning to glimpse Gitlitz's vision: His speeches for the last couple months have been a veritable homage to New Economy productivity gains. But there remain unreconstructed growth-causes-inflation troglodytes on the Federal Open Market Committee, such as Laurence Meyer, who will take some real convincing.
But if you listen to the market, it's betting on the Fed coming around to the new zero-inflation reality.
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Don Luskin is President and CEO of MetaMarkets.com, and a portfolio manager of OpenFund. At time of publication, OpenFund had no positions in any of the securities mentioned in this column, although holdings can change at any time. Luskin appreciates your feedback and invites you to send it to Don Luskin .
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