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Today we examine several fundamental and criticaly questions, to see if they give us come clues as to the direction of the economy and the stock markets: "Why do we have no inflation since the Fed has been growing the money supply at very high levels for a very long time?"; the ever popular, "Is the Fed pushing on a string?" and "Is the United States headed down the same path as Japan?" My analysis will be controversial in many circles, especially the doom and gloom circuit, but will not make market bulls happy either. As usual, I will fall in the Muddle Through Middle, which is precisely where you should be. I first wrote seriously about deflation in the fall of 1998. It has been one of my more enduring themes these last four years. There are deflationary pressures everywhere: too much capacity, Japanese and Chinese deflation washing to our shores, imploding debt, etc. The list is long, and I have written about them extensively in past issues. But I must admit that even as I predicted and demonstrated the presence of deflation in the US and world economies, I was puzzled as to why these deflationary pressures persisted in the face of very strong growth in the money supply. My basic monetarist instincts (a school of thought in economics) said such high growth in the money supply should be reflected in the inflation rate. Japanese Disease Inflation is running about 1.5% over the last 12 months. Over the last four months, inflation is running at a yearly average of less than 0.7%. The explosive first quarter of inventory rebuilding accounted for 80% of the very low inflation we have seen in the last year, and now inflation has seemingly gone back to bed. At current rates, it is in danger of falling out of bed into outright deflation. That is why so many writers are suggesting we are in danger of catching "Japanese disease": a deflationary depression. I must thank economic guru Dennis Gartman for pointing out, and then explaining with remarkable patience, the reason why inflation in not showing up in our economy as a result of the rise in monetary growth. But first, let's quickly document exactly what type of monetary growth rate we are talking about, courtesy of Greg Weldon. Money supply is measured by statistical compilations called M-1, MZM, M-2, M-3 and the Adjusted Monetary Base. Each statistic is a different way of looking at the money supply, and has a different purpose. For instance, M-1 is basically cash. MZM is cash plus money market funds. M-2 starts to add in time deposits and other cash substitutes. M-3 starts to add foreign dollar deposits and large time deposits, plus other items. Today we read that the 13 week rate of change of the growth of M-2 ( a way of measuring the momentum or direction of growth) has risen from 2.9% only six weeks ago to 7.3% today. That is a very large gain. The 13-week change in M-3 is growing at 8.4%. Both measures are growing at over 8% annually. If you go to the St. Louis Federal Reserve database, you will find that the adjusted monetary base, that most basic measure of money, has grown from 596 billion dollars to 682 billion since the beginning of 2001, a jump of $86 billion or 14% in only 17 months! This is sending out alarm bells in every gold bug's heart, as this type of growth should be giving us inflation, and thus a rise in gold. But when you break down the numbers, as Gartman led me to do, the growth due to direct Fed action becomes far slower, and in some cases actually disappears. This insight helps reconcile the apparent conundrum of seemingly rampant monetary growth and the (almost) existence of deflation. One of the things the Federal Reserve is required to do by law is meet the demand by banks for cash currency. If a bank asks for paper money, the Fed supplies it. The currency component of M-1 (cash money in circulation) went from $530 billion to $615 in the last 17 months. This is a jump of $85 billion, or almost exactly 100% of the growth in the adjusted monetary base. Where has this cash gone? Have you or anyone you know buried $85 billion in coffee cans in your back yard? Do you need 17% more cash than you did in 2000? The answer is, "No." Further, if you look at a measure of how fast money is circulating, something called the velocity of money (again on the St. Louis Fed website), the velocity of money has dramatically slowed over the last few years (in itself deflationary, but that's another story). We simply don't even seem to need more cash money. (I should note this is a national average. It is not based upon personal experience. Money seems to be leaving my accounts much faster.) It is my belief that the largest portion of this money has gone offshore. If you go to any third world country, you will find dollars are the local currency of choice. If you live in Peru, Brazil, Argentina, Russia, pick a country in Africa, and much of the less-developed world, US cash is King. Further, if you look at the growth of cash over the last 6 months, it is a "mere" $24 billion. That coincides nicely with the changeover from physical European currencies to the euro. All physical European currencies (marks, francs, lira, pesos) had to be converted to physical euros in the first two months of 2002. I wrote last year that there was a huge demand for US cash dollars, as third world European currency holdings had to be converted on the black market, because if you had hard currency in Zambia or Argentina, you did not want to take it into your local bank for local currency. This is in addition to the underground European economy which scrambled for dollars to avoid reporting their assets to the taxman. For all intents and purposes, this money is not in the US monetary base. It has gone AWOL. That is not to say it could not come back, but the circumstances which would cause a mass flight from US dollars to Brazilian reals or Russian rubles are difficult to imagine. What about the dramatic growth in MZM? That is M-1 (cash and bank deposits) and money market funds. The growth in money market funds has been huge. But that growth did not come from the Fed. It came from investors fleeing the stock market. It is the same with other monetary measures. The growth in each statistic can be explained in the growth of electronic cash, as individuals, institutions and businesses move to cash. This is a conservative movement, away from risk, and much of it is actually deflationary, as it slows down the flow of money, and pulls money out of the fractional reserve banking system. If you look at what the Fed has actually done to directly increase the money supply, apart from their normal liquidity functions, it is statistically insignificant. They are not monetizing the US debt or buying significant amounts of government obligations. They have not reduced bank reserve requirements. All they have done in the last 18 months is lower the Fed fund rates so as to lower the cost of borrowing money, in an effort to jump start the economy. While this is significant, and is in theory inflationary, it has not shown up in the actual inflation rates. Even though the money supply is growing, assets are falling. We all know about the $5 trillion+ (depending upon the day you look) loss of paper assets in the stock market. But much of this was paper assets. The market giveth paper and it taketh it away. More critical is the implosion of actual dollars through bankruptcies. Weldon points out that corporate bankruptcies were $258 billion last year and already $267 this year, with much more to come. Personal bankruptcies were up 5.9% to yet another high. This is well over half a trillion dollars in 18 months. Much of this money is "poofed." Someone loaned a company or individual money, and now they are only going to get a portion, if any, of that debt back. That is dollar destruction and deflationary. It takes money out of circulation. Indeed, it is the debt destruction cycle that the most ardent doom and gloom proponents constantly cite as the primary reason we are about to enter into a full scale depression. Deflation is staring us in the face. The Producer Price Index is down 1.1% over the last year. Crude materials cost are down 6.2%. The Philadelphia Fed tells us the difference between the prices businesses pay for products and the prices they can charge is decreasing. 30% of the categories of the CPI were experiencing year over year declines. The only reason CPI is positive is the rise in the cost of services, tobacco and health care. Yet, service industries are beginning to once again show a net loss of jobs. That means they have profit problems. Real hourly wages actually went down last month, even as output increased. We are working more for less. We now import 33% of the goods we consume in the US. Stephen Roach tells us, "...non-petroleum import prices were still running 1.5% below their year-earlier level in July 2002 following a 2.4% deflation over the preceding 12 months. Importing deflation is not that big a deal in a closed economy. In today's increasingly open US economy, it's a different matter altogether." There are segments of the economy which are slowing. Housing starts are down for the second month in a row, over 5% from May and sales are sliding down as well. Employment growth looks weak, and in some sectors is not growing at all. Consumer spending growth is slowing. Data from Gian M. Fulgoni, the Chairman of comScore Networks, Inc. underscores this. comScore tracks the online buying habits of 1.5 million consumers (with permission). Online sales growth clearly slowed in the second quarter, which was born out in their statistics as well as the dramatically slowing of GDP growth to an anemic 1.1%. Their concern is that the trend is getting worse. July posted the slowest growth rates ever in their data. He writes me, "Based on a belief that online buyers are, in fact, "early adopters," whose buying behavior can be used as a lead indicator of upcoming trends in consumer spending in the U.S. economy at large, we believe this is a clear sign that consumer retail spending has softened substantially... Of particular concern is our observation that the growth rates have continued to decline during the month of July, 2002, portending continued softness in the economy." We Have Not Yet Begun to Push The data shows us we are close to deflation. It also shows the economy is not in danger of starting into a boom cycle anytime soon. I could cite a much larger litany of economic problems than those mentioned above. Now we come to the crux of this letter. Recessions and bear markets are part of the business cycle. It takes a government working hand in hand with a central bank to create a Depression. (Let me state at the outset: I am merely commenting upon the world the way it is. Please, no lectures on the evils of central banking. I have read my von Mises and even had the privilege of meeting with Hayek.) The Federal Reserve recently published a paper analyzing the Japanese deflationary depression. Yes, they had a bubble. Yes, it burst. Yes, the drops in the stock markets look eerily the same. The Japanese dropped their interest rates to 0%, and it had no affect. The term that is in popular use is that the Bank of Japan is "pushing on a string." Yes, the recent drop in rates looks like the US Fed might also be pushing on string. We have had serious interest rate cuts, and yet there is no real recovery. The argument seems to be that if the US economy quacks like Japan and waddles like Japan; we must be headed for a deflationary depression. It is an argument based upon faulty parallels. This Fed paper is significant. The Federal Reserve authorized it, published it and made sure everybody knew they were involved with it. This was to my mind a clear message from the Fed. The paper analyzed everything the Bank of Japan did wrong. It was a long paper. I have often written that the Bank of Japan (and the Japanese government in general) is the only management group which can make Xerox management look competent. Xerox squandered more great inventions than any management team I know of. They should be bigger than both Microsoft and IBM combined, if they had properly exploited their research. Yet today their loans are considered junk. The Bank of Japan, along with their government, has likewise made a bad situation into a disaster. They raised rates and kept them too high. They did not deal with corporate debt, moving to hide it and weakening the bank system while keeping brain-dead corporations on life support. They let deflation become a spiral by not directly monetizing debt or changing bank reserves. They raised taxes, ran huge deficits and funded pointless work projects. Just about everything you could do wrong, they did. In fact, they acted much like the US Fed did in the 1930's where it was a case of wrong policies and then of too little, too late. This paper seems to be saying (or at least I hope it is saying), "We see the problem. We will not let the US economy go into a deflationary spiral. We have tools at our disposal. We will not use them unless we have to, but we will use them if necessary." In short, the Fed has not yet begun to push. Printing cash that is by and large going overseas is not pushing on a string. Investor movement to cash is not pushing on a string. There is serious argument in certain quarters that the economy may be turning around. Indeed, "There is almost no chance of a double-dip recession in the United States and growth in the second half of 2002 will clearly point to recovery, according to research by The Conference Board." Their only concern they suggest is deflation coming from the rest of the world. While you can make an argument that the Conference Board guaranteeing no recession is a sure sign we will shortly be in one, it is nevertheless indicative of the thinking of a lot of economists and businesses who believe things will soon get better. The Fed is hoping they are right. If the economy does Muddle Through, as I think it might, then monetizing the debt or changing reserve requirements would be a very bad thing to do. It would be a guarantee of rising inflation. There are clearly things that could be done by the government to help the current situation, and let us avoid the situation altogether. We could abandon our recent and disastrous protectionist trade policies, and demonstrate that we actually believe in the free trade George W. professes. (Are you listening, Karl?) We could stop the rampant growth in government spending. We could stop taxing dividends at the corporate level, along with a dozen more policy changes. All these things would help the economy. The Fed will only move to fight deflation as a last resort, because the consequences may not be pretty. How will we know when they do? It will likely happen by something called a "bill pass." That is a direct monetization of US debt. That has not yet happened. Gartman thinks that if it happens it will start on the short end of the yield curve, driving money market rates even lower, thereby encouraging savers/investors to find other places for cash. Now, class, please note that monetizing the debt or changing bank reserve requirements is not a path to prosperity. It is far from it. These steps should only be taken when there is clear and present danger of a deflationary spiral caused by an asset bubble bursting and credit implosion. Minor deflation may not move the Fed to act in the hope that the economy will cure itself. Such moves will only be taken because we are in deep kimchee, and as a last resort. (For the record, I understand that deflation caused by increasing productivity and competition is - or should be - the natural order of the world, and is not bad. But the deflation we are experiencing is not the product of improving productivity.) Monetizing the debt will not stave off recession, increase employment or make us more productive. It will simply produce inflation, probably in the midst of a recession, as a recession is the likely trigger for us to go into outright and serious deflation. This will bring us to stagflation, which is easier for business to deal with than serious deflation. Better the devil we can deal with than a new devil we know will destroy. If deflation gets to the point the Fed has to act, it will be a choice between two evils: stagflation or deflationary depression. Which would you choose? Can they produce just a little inflation? Good question. The paper did not provide the equation for "just a little inflation." We would be in new territory, and with very little historical precedent. I am sure central bankers are confident they can adjust without hurting the patient too much, but I am a little more sanguine about experimental medicine by un-licensed practitioners. Could it end up looking like stagflation? Quite definitely the answer is yes. That is why you do not pull that trigger unless you have to. The Real Difference between Japan and the US What the paper did not say is the real difference between Japan and the US, and that is our free market business climate. Betting long-term against the Us entrepreneur is a losing proposition, and always has been. Japan tried to stave off recession by denial. We let our Enron's and WorldCom's go down. We let the dogs die. Japan runs by consensus, and it takes a long time to make decisions and react. US businesses often build consensus on the fly, reacting to a changing environment more quickly than Japanese firms, at all levels. Japan resists change. We embrace it. Say what you will, US corporate management struggles to survive and produce profit, from the smallest firm to the largest. While the US business climate if unchecked can produce outrageous examples of greed and avarice, it also produces prosperity and growth. By and large, most workers and management are honest and competent. In short, we are not Japan. If we enter into a deflationary spiral and depression, it will be because of massive incompetence in the Fed and in our government. Governments can't avoid recessions. That is not in their power. They can only make them worse, or lessen the affects. I do think we still have a serious recession in our future at some point, as we need to clear out the excesses of the recent boom. The Day of Reckoning will come. But it will be a recession, and not a repeat of Japan. Until that recession, we will Muddle Through. Then we will once again hit the reset button, and do what a free economy is supposed to do: create opportunity for those who work and take risks. Secular Bear Economic Cycles My central theme remains: we are in a secular bear market. History suggests it will last for years. Investing under the rules of the 1980's and 1990's will be a fruitless, if not a disastrous task. Absolute Returns are the order of the decade. Finally, I can't help but point out that long term bonds are (finally!) going in my long-predicted direction. We will see if this move is for real, but I think it is. I think there is still some room for bonds to rise, and long-term rates to drop before the next rate rise cycle begins. This is because I think there is more disinflation/deflation in our near future. Why the Fed Did Not Cut Rates The statement from the recent Fed meeting clearly stated that the economy is biased to the downside. It reads like my letters have for the last year. We are in a Muddle Through Economy. Why not cut rates then? If the Fed fund rates had been at 4%, they would have cut them and cut them again. But now they are at 1.75%. A 0.25% rate cut would have little, if no, affect on the economy. Greenspan is down to seven 25 basis point cut bullets in his holster. The last three, to take us to zero, would be seen as desperation, and would be worse than doing nothing. The next four are only good for emotional impact. He will save these bullets for an emotional moment, when they might do some good. For instance, if we attack Iraq in September, a rate cut shortly after might be seen as calming. What if there is another terrorist attack? (I seriously doubt we will attack in October. That would be too political. Either in September or after the first week in November is my guess.)
John Mauldin
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Or it could simply be that the Fed won't "fight" deflation because the Fed, unlike the author quoted above, actually understands what is "deflation."