Steve Saville on inflation/deflation and the bogus bond rally
speculative-investor.com
Money Supply and Demand
In each of his past two weekly e-letters John Mauldin(*) said that recessions are by definition deflationary. Furthermore, he made this comment as if it was such an obvious truth that no proof was required. The only problem is, the historical record says otherwise.
Like many analysts Mr Mauldin confuses cause and effect when it comes to inflation and deflation, but for the purpose of this discussion it really doesn't matter whether we correctly define inflation and deflation in terms of changes in the total supply of money and credit or whether we incorrectly define them in terms of changes in the Consumer Price Index (CPI). Whichever definition we use, there have been five recessions in the US since 1970 (treating the 1980 and 1981-1982 downturns as separate recessions rather than one long 'double dip' recession) and each one was inflationary. In fact, the 1974-1975, 1980 and 1981-1982 recessions occurred in parallel with the highest year-over-year increases in the CPI of the past 50 years.
Now, in believing that economic weakness generally goes hand-in-hand with deflation Mr Mauldin has plenty of company. In particular, we regularly see/hear arguments to the effect that excess capacity leads to deflation (where deflation is, once again, incorrectly defined as a fall in the general price level). However, the following chart shows that there was a strong INVERSE correlation between capacity utilisation and year-over-year changes in the CPI during the 1970s, meaning that the greater the amount of spare capacity the greater the increase in the CPI over the course of this decade, and that there has been NO meaningful correlation since that time. As an aside, the lack of correlation between the CPI and capacity utilisation since the early 1980s is probably due to 'management' of the CPI.
This got us pondering: given the obvious evidence to the contrary, why do so many analysts assume that recessions are deflationary?
The answer, we suspect, is that it WOULD make sense to think of recessions as being deflationary IF changes in the supply/demand equation for goods and services were the main determinants of the general price level, that is, if changes in money supply and demand could be ignored. In other words, it is possible that many analysts are starting with the premise that money is stable/neutral and, therefore, that a drop in aggregate demand will necessarily result in a drop in the general price level. As is always the case, though, when you start with an incorrect premise and then apply flawless logic you are GUARANTEED to arrive at the wrong conclusion.
In reality, the general price level tends to be influenced more by what is happening to money than by what is happening to the demand for goods and services, the result being that prices can continue to rise in the face of falling demand if the official currency is being devalued at a fast enough rate. And the time when the currency-devaluation efforts of central banks generally swing into high gear is during a recession.
The bottom line is that if there were stringent limits on the supply of money then it would be reasonable to assume that a recession would lead to a fall in the general price level. However, under the current monetary system -- a system in which central banks have the power to create unlimited amounts of money -- recessions will, more often than not, lead to higher prices throughout the economy. That is, given today's monetary environment it makes more sense to say that recessions are, by definition, inflationary.
*Although we are in disagreement with Mr Mauldin on some important issues, we've found his weekly e-letter (http://www.frontlinethoughts.com/) to be informative and worth the read. Also, it is good value (it's free).
Bonds
It seems to us that many analysts are trying to read too much into the on-going rally in the bond market. At the most basic level bonds are rallying because there are more buyers than sellers, but as explained in previous commentaries the major buyers aren't buying because a) they think economic growth is about to collapse, or b) they think there's an absence of inflation of a serious threat of deflation, or c) they think bonds offer a good return on investment at current levels. They are, instead, buying because the excess dollars they obtain as a result of their trade surpluses have to go somewhere; or because the spread between short-term and long-term rates is still wide enough to make carry trades lucrative; or because Treasuries must be purchased in order to hedge exposure to other forms of debt (mortgage-backed securities, for example). This makes intuitive sense and is also supported by market action because over the past few months we have seen a pronounced shift towards growth-oriented investments, such as the industrial metals and emerging markets, something that would NOT be happening if US bonds were being pushed higher due to deflation fears or any form of 'flight to safety'.
Our view is that bonds are where they are today due to 'artificial' support on a grand scale and that once this support is reduced -- something that will probably happen in the not-too-distant future -- bond prices will tank. This makes us intermediate-term and long-term bearish on bonds. Also, with the T-Bond price hard up against important resistance we are short-term bearish. This doesn't mean, though, that we view the bond market as an attractive short-sale candidate (we don't). Instead, we'd steer clear of the heavily-manipulated bond market on the basis that when bonds eventually do plunge there will be a lot more money to be made being short other markets. |
