Comstock Partners, Inc.
Rising Prices Are Not Necessarily Inflation
February 28, 2003
Deflation Indicators
Some observers believe that the 1.6% rise in the January PPI means that we deflationists have already been proven wrong. We disagree. In our comment of February 21, we made the case that inflation is a monetary phenomenon. In another comment on February 23, we pointed out some non-monetary factors associated with inflation and deflation. In those two comments, we indicated that both the monetary and non-monetary factors strongly leaned toward deflation as the more likely outcome in the period ahead. This comment will attempt to conceptually explain the difference between rising prices caused by exogenous factors and a generalized inflation arising from excessive money supply and product scarcities brought on by a lack of excess capacity.
In the current case the energy complex has just experienced sharply rising prices (especially natural gas, but also in gasoline and heating oil) that we believe to be deflationary and not inflationary. For instance, if utility bills go up substantially because of a steep rise in natural gas prices, either due to a potential war or cold weather, this is not inflation. In fact, we would consider it deflationary because it leaves the consumer with less money for consumption. Remember, as we stated in an earlier comment, inflation and deflation are monetary phenomena. Inflation takes place when the Fed increases bank reserves (by purchasing Treasury securities from dealers). When the bank loans the freed up money to the private sector to buy goods and services, and the increased demand for these goods and services drives up the price—that is inflation. On the other hand, if prices rise due to exogenous or extraneous circumstances (like a potential war) it is more deflationary than inflationary.
If you agree with the above premise it seems to make no sense to monitor prices to determine potential future inflation. It makes more sense to monitor the money supply, the velocity of money supply (amount GDP increases per dollar of money supply), and total debt. As you can see in the M-2 chart we have linked at the bottom of the comment, the year over year growth has declined from 10.5% in late 2001 to 6.5% now, and M-3 declined from 13% then to 6.2% now. The velocities of M-2 and M-3 have been falling sharply for the past 5 years and the decline is the largest since World War II. In addition the economy is encumbered with excess capacity while GDP is well below its current potential. Anecdotally, most corporations say they have little or no pricing power, and with the major exceptions of energy and healthcare, we believe they are correct.
We have also included some debt charts at the bottom of the comment. These charts are currently making new highs in almost every category. However, if our deflationary case is correct these debt charts should level off soon and start to decline since deflation is associated with debt reduction either voluntary (debt repayments) or involuntary (bankruptcy). We believe the slowing money supply accompanied by less GDP produced by each dollar of money supply (velocity) is a precursor of debt reduction. Other indicators to monitor in order to see the victor in the battle of inflation- deflation would be the long-term charts of economically sensitive commodities like copper and lumber. Also, the quality spreads between junk bonds and high quality bonds should continue to widen if deflation is perceived to be the more significant risk. This spread is at or near record levels presently.
Again, our largest market bet is against the U.S. stock market and if it declines because of inflation or deflation, our mutual funds should do well. They will do a little better if the deflationary case plays out as we expect.
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