This Time it's (never) Different...

July 15, 2008 seems to have thus far marked a temporary bottom in the major US stock indices. I honestly did not believe that the low put in at the time of the Bear Stearns rescue would be broken so dramatically when it was retested. It seems that the major economic event to push the markets over the edge was the concern over the financial viability of the GSE’s: Fannie Mae and Freddie Mac. However, this was not really new information; These two companies have been on regulators radar screens as having a myriad of problems that only with a set of sweeping reforms could these institutions continue operating (with confidence) as a going concern. To be an institution in corporate purgatory stuck with the task of appearing to be profitable while at the beckon call of bureaucratic legislators and lobbyists is an exercise in futility. Nevertheless, Wall Street woke up to the troubles of Fannie and Freddie and the fact that the housing downturn and credit crunch could have a long way to go before it’s all over. Thus, financial stocks and the broader market were severely beaten down to the point of ridiculousness; some of the larger financial institutions that had a very limited chance of default (further confirmed by tight CDO spreads) were trading at fractions of their book value. When this type of old news hits the market so hard (and with very heavy volume on financials) a capitulation environment of forced selling is a very real possibility. In light of this information, it is my opinion that this low point in equities will hold, unless some sort of doomsday scenario (see last weeks post) actually comes to fruition.

A lot of talk in popular financial media has been the argument concerning the current market as being in a bear or bear-cub stage. The former indicates a more pronounced size and duration of declining equity values from peak to trough. Obviously the outcome will be determined by my favorite economic indicators: jobs, inflation (monetary tax), fiscal tax policy and the ever important home and credit lending conditions. Of course, this really can only be determined once we are through it all; but until that point, speculation will remain rampant… and I will participate whole-heartedly!

I would like to turn now to the topic of inflation, as it is a troubling factor whose cause has of late been a mystery to me. As a friend and colleague at my work, Paul Tabak, pointed out to me recently “Inflation is always and everywhere a monetary phenomenon”; those are of course the words of the legendary liberal economist, the late Milton Friedman. As too much money chases too little goods, prices are bid up as inflation accelerates. Friedman advocated a slow and steady growth rate in the money supply that was tied to some formulae accounting for GDP growth (as well as other factors). The most important feature of this regimen is that a steady and predictable monetary base would provide an anchor for prices allowing businesses to make decisions based on more reliable and known pricing information. I am a great believer in this philosophy; however, careful examination of current data seems to point to contradictory causes of the current inflation position. Firstly, growth in M1 since 2006, and most importantly through the Fed’s latest easing period has shown no signs of increasing. How should one interpret easy money policy on the part of the Federal Reserve when growth in the monetary base has been stagnant? In light of this information I would tend to focus on two pieces of information that could help in uncovering inflation causality: growth in a wider measure of the money supply (such as M3), and the cost-push inflation scenario. Unfortunately the Fed no longer tracks M3, which would make it difficult to speculate how this wider money aggregate (which includes the total amount of money held by both bank and non-bank institutions) is currently behaving. Perhaps the velocity of money is consistently declining as hard commodity and inflation speculation has caused cash hoarding among the most influential institutions (thankfully, this is a topic that is outside of the realm of this blog and reserved mostly for academia).

Cost- push inflation occurs when a set of important goods (such as food and oil) increase in price while there is no close substitute for consumers. This theory has been largely debunked citing that a central bank would have to accommodate this scenario by increasing the stock of money available to the public to chase the price of these goods. Without an increase in the money supply, the price rise in these goods would simply eat up a greater proportion of spending ultimately resulting in either behavioral shifts in production or consumption or it would give rise to recessionary conditions. Since the stock of M1 has not increased during this time, inflation from this source would seem to be an unlikely occurrence. Similarly, there seems to be no hangover effects from past inflationary periods causing a wage/price spiral putting upward pressure on the price level. More to the contrary, a low level of inflation coupled with mounting data pointing towards a weak job market should put to bed any concerns over a wage effect on prices. So what are we left with??? The only thing I can surmise from this stockpile of ambiguity is that broader measures of the monetary base, such as M3, are likely to be trending upwards, which is causing a steady increase in the core level of inflation. Volatile commodity and food prices are likely to have short-term impacts on the aggregate CPI basket of goods, which should however be mitigated over time as expectations are adjusted for the price appreciation of these goods.

Inflation is a significant concern to both the economy and the health of the ongoing long-term secular bull market in US equities. Inflation is the most significant tax on growth, can be a destroyer of currencies and therefore should be of the utmost concern to policy makers at all levels of government.