Camouflage and mimicry are common evolutionary strategies, and for good reason. It is much more efficient for a potential meal either to hide from a predator or to look poisonous than to acquire all of the necessary armament for actual defense. And a word of warning to any of you contemplating an excursion to a tropical rainforest: Don't let your last words be "Oh, what a pretty frog!" Markets often conceal their actual character behind what Churchill termed, within the context of wartime espionage, "a bodyguard of lies." Consider the trouble we have had in the past two years deciding whether we are in an epoch of deflation, forestalled deflation, reflation, regular inflation or the dreaded stagflation. To extend the evolutionary analogy, our government-data sensory mechanisms -- so necessary for environmental perception -- may have been hijacked by some sort of hallucinogenic parasite. Do not touch the mushrooms in the Bureau of Labor Statistics cafeteria.
The relationship changed once again in the 1990s. After the rate hikes of the 1994 tightening cycle ended, growth in the money supply continued to surge and even ignored the rate hikes of the 1999-2000 cycle. As an aside, those who blame the Federal Reserve for fueling the bubble should glance at this chart and guess how high the federal funds rate would have to have been to squelch the monetary growth of this period. Only the bursting of the stock market bubble led to a collapse in the bank lending so necessary for the expansion of the money supply. In early 2001, I feared that the aggressive rate cuts would lead to an expansion of economic activity and credit demands, which in turn would lead to strong money supply growth and eventual inflation. This was giving the Fed way too much credit (no pun intended) for its ability to influence the money supply. In retrospect, the Federal Reserve has been far more effective, probably unintentionally, in influencing asset prices, as both the stock market boom of the late 1990s and the present real estate festival attest. Moreover, the old monetarist assertion that inflation is everywhere and always a monetary phenomenon may need a little modulation. The rapid disinflation of the early 1980s was not led by a decline in money-supply growth, and the experience of the 1990s showed that high money-supply growth need not produce subsequent inflation. Now we are seeing price levels rise after a period of rapidly slowing money-supply growth. That misdirection lasted for just over two months. A spate of weaker economic data has ended the flattening of yield curve, and while the weaker dollar and higher commodity prices of the past month were consistent with the 2003 experience, the weaker stock market most certainly is not. If the Federal Reserve is a reluctant cop on the monetary beat, we may see a return to the accommodative policies and rhetoric of 2003 very soon. But do not expect to party like it's 2003: While bonds, commodities and foreign currencies will benefit, stocks will not. This reflation attempt, whether accompanied by rising monetary aggregates or not, will have higher reported inflation, notwithstanding last week's producer price index and consumer price index reports, slower economic growth and profit growth and the prospects for higher federal taxation with which to contend. The very worst mistake we could make at this juncture is to treat inflation as public enemy No. 1. Lurking behind this camouflage of higher prices is a worse danger, and that is a deflationary collapse of credit. All of these economic states are morphing into each other quickly, and it is understandable how advocating reflation to avoid deflation while risking inflation could be a little confusing. But the reward is avoiding a repeat of the 1930s or Japan in the 1990s, and that is worth a little time and effort.