The markets heard echoes of the 1970s last week and recoiled reflexively.
If you lived through those years, you don't want to repeat the experience; bell bottoms and disco were hardly the worst of it. There is nothing quite like a rumor of inflation to ruin a party mood for investors, and just such a rumor has begun to gain credibility across the exchanges.
Traditional inflation hedges have taken off. Both gold and silver have soared to levels never seen before -- excluding only a few months in 1980 -- and the London Metals Exchange Index, covering six base metals, has nearly doubled in six months. Some of this is due to anticipation of a broadening global boom as Europe and Japan begin to add their energies to those of North America and non-Japan Asia, and some is due to speculators' excursions beyond the energy complex. Whatever the reason, the bullish action lately has been in what, back then, were called tangibles; financials (i.e., stocks and bonds) have, as before, taken the short end of the stick.
It is not clear how much of the recent price moves should be attributed to economic fundamentals and how much to "animal spirits." The parabolic price action in the metals smacks of speculative fervor but the global economic backdrop suggests something more permanent. In any case, the two motivations can't be entirely separated.
After all, we have had 25 years during which the primary trend has been one of disinflation, initiated by the resolve of Volcker monetary policy and continued by, among other influences, the Soviet collapse, Japanese deflation, Teutonic standards in European integration and the emergence of China, India and other little economies with big populations.
But, according to lyrics attributed to the quiet Beatle, all things must pass. It stands to reason that a disinflationary trend must be self-delimiting: when inflation reaches zero, disinflation is finished and a new primary trend takes over, either deflation or reflation. The deflation scare of 2002-04, and the "risk management" reaction of the Greenspan
-- with "Helicopter Ben" providing talking points -- shows that a little inflation is much to be preferred to a debt-deflationary round of price destruction.
Markets hear "a little inflation," think "a little pregnant," and hit the bids for financials while lifting the offerings for tangibles.
The deflation scare earlier in this decade resulted in widespread agreement that a little inflation -- between, say, 1% and 2% -- is safer than none at all. But since global inflation measures are now around that top-most level of toleration, and well above it if several inconvenient commodities aren't excluded, it is an open question as to how the dynamic processes that drive price action can be managed in such a way as to keep those prices on the chosen path.
My surmise (surmise sounds so much more thoughtful than guess, doesn't it?) is that the suddenness of parabolic price action in the metals this year, coming after a long buildup of global imbalances with latent price implications and a persistent move in energy prices, means that speculative forces are providing most of the push. It may not be a coincidence that these prices took off about the same time that a Fed "pause" became realistic.
But this is no longer the 1970s. This time it is more of a "demand pull" condition than a supply shock that is bulling the prices of commodities. Back then, the rise and spread of inflation was stoked by ill-considered monetary policy reaction to a negative supply shock that occurred when King Faisal withheld Saudi crude oil, thereby wielding the "oil weapon" in 1973's October War.
The Federal Reserve still can't print oil, any more than it could when Arthur Burns ran the place, so it is very much in the position of price-taker; it is not the prime cause that market chatter too loosely ascribes to it. (To describe yourself as "data dependent" is to concede that you must react to events outside your control.) The demand pull pressures that are driving up the price of oil and other raw materials have intensified on merely the rumor that Japan and Europe will add their weight to global economic momentum. If their recoveries are not aborted, it begins to look more and more like a world of "excess demand," a term that hasn't been used much since the Carter Administration.
In the 1970s, the Burns Fed made the judgment that soaring oil prices should not be met with stringent monetary restraint. It was a "finance" vs. "adjustment" question. Costly oil reduced the real incomes of oil consumers and tight money would only compound the problem. The politics of the time, and a hopeful naiveté that prices would fall back, lead to an attempt to avoid adjusting the American standard of living down to its new, lower real income level.
OPEC inflated its prices to us, and we inflated ours to them. The result was devastating to returns on stocks and bonds. Our game was up when oil exporters realized that they'd rather have oil in the ground than paper money in Western banks, and the hard work of adjusting our living standard downward began with the Paul Volcker chairmanship.
Demand-pull pressure on raw resources is likely to be a fact of economic life for many years. The competition for those resources will keep a firm bid under them, although it will periodically get carried away with speculative excess and so be subject to wrenching pullbacks. The Bernanke Fed, like that of Arthur Burns, will have to balance the "finance vs. adjustment" problem in reaction to the data as it comes.
If the judgment is that American real incomes are semi-permanently reduced by the competitive demand effects of other large populations on the world's scarce resources, the only course available will be to adjust our living standard to our means. The Arthur Burns policy inevitably gave way to the bitter medicine of Paul Volcker, for which we have had 25 years to say thanks.
Parabolic Price Pressures Prevent a Fed Pause?
Much of what I read these days seems to be predicated on a view that the issue facing the Fed is to raise rates enough to cool the housing boom but not so much as to kill the industrial and service sectors. I think that's correct but incomplete. As the dollar falls, on a mirror trajectory lately to that of metals prices, the risk rises for the 25-year trend of disinflation.
In a world of scarce resources, we haven't had much competition since the 1970s. Among the results of that are today's global imbalances on current and capital accounts. Those imbalances will be mitigated when Japan and Europe increase their call on the world's resources, but that might mean either a rebirth of inflation, or that Bernanke goes to school on the Volcker years rather than on the blessed interlude of Greenspan times.
Jim Griffin is economic consultant and portfolio adviser to ING Investment Management and its Hartford-based unit, ING Aeltus, which manages institutional investment accounts and acts as adviser to the ING Mutual Funds. His commentary on the financial markets is based upon information thought to be reliable and is not meant as investment advice. While Griffin cannot provide investment advice or recommendations, he appreciates your feedback;
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