The Confidence Game
By James J Puplava CFP, March 28, 2005
All right, now that the Fed has gotten everyone's attention what happens next? Will the Fed begin raising interest rates aggressively abandoning its slow and easy approach to raising interest rates, or is this blustering on part of the Fed? The markets have been caught off guard and are now reacting to what was obvious all along. Inflation is on the rise and it should not surprise anyone, but it did. Certainly higher energy prices are a factor. Energy prices impact everything from the cost of factory output and the price of consumer goods, to the cost of food. Rising energy is only one factor. The costs of most raw materials have been rising for over three years. Since hitting a nadir in October of 2001 the CRB index went from 184 in October 2001 to 322 in March of this year. That represents a 75% increase in just three years.
Many of the components of the index have gone much higher, such as the cost of oil. Other raw material prices such steel, iron ore, and coking coal have gone even higher. Recently Brazil's Companhia Vale do Rio Doce and Australia's Rio Tinto raised iron ore prices by 71.5%. The price of coking coal is set to rise by 121% starting in April. According to experts, the rise in price of most commodities is expected to continue. The reason is that demand continues to rise much faster than supply, thanks to the trend in global industrialization. A multidecade bear market in commodities which lead to falling commodity prices, disinvestment and a lack of new investment has kept supply from meeting demand. It will be years before enough new supply is brought on stream to handle demand.
Skeptics cite China as the main culprit for higher commodity prices. Many experts are now predicting that a slowdown or breakdown in China's economy will cause commodity prices to fall. Some have said that commodity prices have peaked along with energy. I disagree. China's growth rate may slow down to 8-8.5% this year, but a hard landing is a ways off. China's fixed-asset investment rose 24.5% in January and February. That is down from last year's pace of 53%, but it still remains healthy. Demand for raw materials has slowed down, but it also remains robust. Steel consumption will rise by 12% this year and the demand for oil will increase by 7.9%. The increases are less than last year, but in a global economy where there is little slack in capacity for most raw materials, those growth rates are enough to keep prices rising.
Therefore, pipeline inflation pressures are most likely to persist. Especially since interest rates here in the US are far below true inflation rates. Furthermore, year-over-year money growth is ahead of economic growth rates. The monetary aggregates, which have been growing at 5-6%, are still above GDP growth. Despite the recent rise in interest rates, borrowing continues in all sectors of the economy unabated. High debt-equity ratios persist because the Fed has created a very attractive environment for borrowing. Consumers and businesses are tempted to borrow to excess because the cost of borrowing is still relatively low in relation to potential profits or asset price inflation (real estate being a prime example).
The Fed's problem is that it has created myriad asset bubbles that are making it difficult for it to deflate, especially now given the huge debt burdens that keep building in the US economy. When asset values are appreciating faster than debt service costs as a result of declining real interest, not only are risk premia reduced but the incentive to borrow is magnified.
As long as real interest rates are kept below the rate of asset inflation, the debt pyramid will continue to grow. The only thing that could bring this to an abrupt halt would be a rise in real interest rates which now appears unlikely. As Stephen Roach has recently written, with inflation running at an annual rate of 3%, a neutral rate would be somewhere in the neighborhood of 5.75%. That is not going to happen. A federal funds rate of 5.75% would bring this debt-laden economy to its knees. It would end the �carry trade,� unwind the bond market bubble, send stock prices crashing, and puncture the real estate bubble.
Besides, I need to make one thing perfectly clear: as long as the supply of money and credit continue to grow at rates much faster than the economy, we will continue to experience higher rates of inflation. As the graph of M3 shows below, since Greenspan took over as chairman of the Fed, we have had above average money growth for well over a decade.
In fact, I can’tthink of a time where we have had negative money growth rates in this country in the past 50 years. As long as the supply of money and credit continue to grow, we will not experience real DEFLATION. The problem for policy makers is that everyone is a Keynesian today. Keynesians are really monetarists at heart. Every economic problem in the eyes of most Keynesians can be solved by creating more money, money to stimulate the economy, and money to stimulate the financial markets. As a result we have two distinct avenues for money to circulate in our economy. The first is in national product transactions (the real economy), and the other is the capital markets. So in effect, we have two circulatory routes for money creation: the capital markets and the economy. It is important for the reader to understand that the principal depository for money creation in today's financial economy is the capital markets. A recent example of this was the stock market bubble of the late 80's and 1990's. As shown in the four graphs below of the money supply and the stock market, the financial markets became the principal depository of excess money creation in the 1990's.
The sequence of events is that prices in the economy remain steady temporarily while stock prices rise and interest rates fall. Virtually all, if not the majority, of excess money created by monetary inflation goes temporarily into the capital markets. This forces up prices of real values in the capital markets and this is, in reality, one form of simple price inflation. Very few think of it this way. Instead it is referred to as a bull market.
Eventually, money which flows through to the capital markets winds up back in the real economy through excess profits and capital gains. This takes place only as long as confidence is maintained in the capital markets. If confidence is lost, then a general exodus of money from the capital markets can move back into the national product driving up the cost of goods. As this takes place we begin to see rising prices in goods or what is more commonly referred to as inflation. It was there all along; it was just disguised as a bull market in financial assets.
After the shocks of the bear market in equities in 2000-2002, the increase in consumption brought about by an expanding money supply and low interest rates was masked to some extent by the increase in the US trade deficit. The inexorable rise in America's trade deficit was another avenue of absorption for the increase in demand brought about by excess money and credit. Like the rise in the capital markets in the last decade, it became another depository for inflation.
So where are we now? We are, in my opinion, in uncharted territory. Where we are heading is going to be a tough call to make precisely. My best guess is that it is stagflation that eventually turns into hyperinflation by the end of this decade. One reason I believe this is the "Law of exponential inflation." It is a law of geometric progression. Every inflation must compound itself at a geometrically increasing rate in order to have the same beneficial effect as in the beginning. Once it begins it must get progressively worse. This can take place as long as paper wealth maintains its credibility. So far, monetary inflation has been reflected in rising paper wealth, rising stock prices and bond prices, and more recently, rising real estate prices. As long as this illusion persists with the people, all is well for the inflationist. As long as paper wealth continues to rise in value most individuals will see this as a bull market and not by its real identity, inflation. If confidence is maintained, then an exodus out of paper wealth can be forestalled temporarily. For if money wealth is repudiated then the supply of real values drops by the fall in paper wealth giving way to a rise in prices in real values. To some extent this is what has happened to real estate.
Currently, there are signs that inflation is about to accelerate despite any pronouncements by the Fed it will remain well contained. Government budget deficits are expected to accelerate as is private debt. The colossal expansion of paper wealth is the single most important factor in containing inflation. It is the major reservoir for accumulated inflation past and present. "A man who watches for inflationary storms must keep a weather eye on the paper wealth."
As this paper wealth expands, the real temptation for government will be to inflate it away. Inflation erodes the real value of paper wealth and keeps it at more manageable levels. There are clear signs that this is indeed the case, for there is no appetite in Washington these days for restraint. The "Big Spenders" are in charge in both parties. Washington wants money to fight a war, money to balance a massive entitlement imbalance as well as create new entitlements. The politicians have promised the voters more cookies and lollipops and I doubt that they will disappoint. The electorate wants more benefits from Washington, not less. So the trend in spending is more on the upside than it is on restraint. As the next few graphs demonstrate, the budget trends are getting more expansionary. This means bigger deficits which will require even larger amounts of money.
Paper wealth will continue to expand as our high-consumption economy relies more heavily on asset markets to sustain both spending and saving.
As for the run-away inflation, it isn't here yet, but there are clear signs it is close by in the real estate markets. The real estate markets are now running on helicopter money. You can buy a million dollar home in southern California with virtually no money down. Through the use of a piggyback loan individuals who lack the substance for a down payment can borrow the money by using a home equity loan or line of credit. If your income doesn't qualify you for a million dollar middle class home, you can apply for a "stated income" loan where you tell your lender what your monthly income is but provide no proof. It may cost you an eighth or quarter of a point in more interest. For most homebuyers this is a nominal cost since real estate prices have been rising much faster than mortgage rates. If that doesn't do the trick, you can always apply for a minimum payment ARM. This allows you to make a minimum payment on your loan and add the rest of the payment on to the loan balance each month.
ARM's, interest only loans, piggyback loans, and minimum payment loans are accounting for the majority of mortgages on new homes sold here in San Diego. It is what is allowing the local real estate market to continue to inflate. I was stunned to find out that the new community going in next door to where I live is selling briskly. One builder told me that the first five phases are sold out and they have a growing waiting list for the next phases. This is remarkable when you consider the average price of a home in this development is a million dollars.
This supports the thesis above that as long as the rate of interest is less than rate of asset inflation, debt expansion will continue. What we should have learned from the stock market bubble of the 90's is that asset bubbles can continue to inflate and last for much longer periods of time as long as the supply of money is available. Concomitant to asset bubbles inflating is faith in money itself. Fiat currencies are a function of faith. There is nothing backing them other than faith. To create and use fiat money, each one must believe to give paper money value. That is what gives value to worthless pieces of paper. As long as the holders of money wealth believe in its value, the inflation game will continue. As long as inflating assets values are looked upon as a bull market, as long as the trade deficit is seen as benign, the paper wealth game can continue. It is all part of a confidence game to convince individuals that paper money has value. It is only when that belief or confidence is lost that real problems surface. That is when the general public wakes up to the fact that they have been duped.
For now the bond market has been mollified that there is no inflation, or even if it arises, the Fed will keep it contained. The financial markets appear to be pacified and content that the Fed is on the job. Now that inflation is starting to appear everywhere, the Fed has changed its language. The current interpretation of that language is that the Fed is about to get tough and aggressive with its rate hikes; perhaps going to half point hikes beginning in June. That should keep inflation contained. But I suspect the language change is all part of the confidence game. It is all part of the Fed's attempt to eliminate the �conundrum� in the bond markets. The Fed wants long-term rates higher in an effort to keep asset bubbles from going parabolic. California real estate is a good example of a bubble going parabolic. What else to you call real estate prices rising 20-30% a year or a median home price of $581,000.
As far as a hard call on interest rates, I don't see it. The US economy has too much debt that needs to be sustained. That debt is price sensitive more so today than it was in 1999 and 2000. Another point or less in rate hikes is all we will get before things start falling apart. The US economy is like a drug addict, addicted to easy credit. I doubt if the drug dealers or suppliers of credit are about to deny that credit. The money supply and the monetary base are still in an expansion mode. Our asset markets and wealth creation are narrowly balanced on a thin margin of low interest rates. It will remain that way for a long time. To deny credit or make it more expensive as the Volker Fed did in the late 70's is out of the question. The economy and the financial markets have become far too levered. The Fed risks collapsing the economy and the financial markets if it gets too aggressive, it is one reason why it has allowed the money supply to grow. Look for the Fed to try another tactic as it appears a rise in interest rates has run its course. The next tactic will be to bring the dollar down.
Look for the Fed to change tactics at the first sign of economic weakness or break in our asset markets. Turmoil in the bond market and the stock market could be coming our way very shortly. Oil prices are also headed higher. The combination of higher energy prices and interest rates is a lethal combination for not only the economy, which is propped up by asset bubbles, but also the financial markets and the plethora of "carry trades" that are visible in just about every sector of the US economy. The US government is engaged in the "carry trade" by financing its debt with short-term paper. Over 75% of the government's paper is short-term and will be rolling over in the next three years. Short-term debt is what has kept the government's interest costs marginal despite growing debt balances. Consumers are also engaged in the "carry trade" by taking out short-term interest-only loans, ARM's and home equity loans.
Finally corporations are playing the "carry trade" through interest rate swaps. These trades are staring to unwind as spreads begin to widen for all classes of debt from investment grade corporates, to high yield and emerging debt. Major financial upheaval is on its way. A few are forecasting an "April Avalanche" for the financial markets. One market seer, Woody Dorsey, sees an April avalanche for stocks into mid to late April to be followed by a May rally. Dorsey also sees a new high for oil in April. The myth of a decline in demand that will accompany a slowdown in China's economy is about to give way to hysteria in the oil markets.
The coming turmoil in the financial markets should lead to a change in course at the Fed. Look for Greenspan to begin talking down the dollar as the Fed's rate-raising cycle nears completion. The Fed will look for a lower dollar to do what it is unable to do with interest rates, which is to reign in the trade deficit. This too will fail. But that won't dissuade policymakers from pursuing the course of dollar debasement. In the meantime the confidence game will continue with the financial markets. The Fed will continue to play down inflation and the financial markets will continue in their belief that the Fed is an inflation fighter. It is a symbiotic relationship that benefits both parties.
A drop in oil prices to $54.05 a barrel help to give stock prices a lift. The Dow Industrials gained 42.78 points to close at 10,485. The S&P 500 rose 2.86 points to 1,174.28 and the Nasdaq gained 1.46 points to close at 1,992.52.
Decliners lead advancing issues by 19-14 on the NYSE. Big board volume was light with only 1.3 billion shares trading hands.
The major indexes have been drifting lower in short spurts since early March. Worries over inflation, rising interest rates and rising energy prices is causing the financial markets to break down. Credit spreads are widening again which indicates the markets are beginning to price in some degree of risk.
The benchmark 10-year note lost 11/32 with the yield rising to 4.62%. Gold prices added $1.20 to close at $426 an ounce.
 Dying of Money, by Jens O. Parsson, p.131
© 2005 James Puplava