January 16, 2012

Inflation

“Inflation is taxation without legislation.”
– Milton Friedman

“By a continuing process of inflation, government can confiscate, secretly and unobserved, an important part of the wealth of their citizens.”
– John Maynard Keynes

“In the absence of the gold standard, there is no way to protect savings from confiscation through inflation. There is no safe store of value.”
– Alan Greenspan

Housing Stall And More QE?

For all the efforts of the Federal Reserve Bank to shore up the housing market, it may have been for naught. The Fed started buying $1.25 trillion of mortgage-backed bonds in early 2009, and since that time according to the S&P/Case-Shiller index, the value of housing in the U.S. has fallen 4.1 percent, (down 32 percent from its 2006 peak).[1]  It’s now gotten to the point where the Fed is apparently considering recycling paid off mortgage debt by purchasing roughly $200 billion of mortgage bonds in 2012 (20 percent of new loans).[2]  Certain officials at the Federal Reserve are reported to be supportive of Fed purchases adding up to as much as $750 billion.[3]

Even though Fed policies have driven mortgage rates to all-time lows, homebuyer borrowing in 2012 is forecast to be at the lowest levels in 15 years.[4]  A shaky job market, continually falling home prices amid foreclosures, and tougher lending standards seem to be defying Fed intervention.  Then again, why wouldn’t they?  Since when have bureaucratic central planners (in this case the Fed) ever been able to defy economic gravity?  After years of exploding mortgage credit, lowered lending standards, and correspondingly bubbling real estate prices – the regression to the mean seems to be in full tilt.  Also exacerbating the problem is an aging population which sees retirement approaching, and thus the need to pay down debt and save.

Without the Federal Reserve Bank funding potentially hundreds of $billions in past and future mortgage purchases (via dollar-debasing money printing) – housing might very well be in free-fall.

As I see it, the housing sector is nowhere near a real recovery as deleveraging continues.  I believe the Fed will print like mad in an attempt to prop it up.

The Inflationary Path

Without central bank intervention, I believe the developed world by now would have experienced a large-scale, steep deleveraging consisting of paid down (or erased) debts, plummeting prices, along with increasing savings. An economic deleveraging can result in a contracting supply of money and credit, along with contracting economic activity.  If serious enough, it becomes a depression.  Following a massive credit binge, this phenomenon is natural (individuals who turn around their financial act experience this on a personal level – as do businesses).  However, in a heavily credit addicted/dependent economy/society – a depression can result in jobs and homes lost, bank runs, insolvency, and large-scale social unrest.  The Great Depression got Herbert Hoover un-elected.

Another choice governments have in the current environment is to inflate (print money).  The high inflation scenario results in currency debasement and rising prices.  Currency debasement benefits net debtors (many Americans) – including the biggest one (the U.S. Government) as debts are paid back with watered down dollars.  The poor, along with people on fixed incomes are hurt as rising prices cut into their purchasing power.  Increasing percentages of incomes are spent on necessities (food and energy), and less on everything else.  The middle class tends to experience declining discretionary income as well.  Also victimized in the inflationary scenario are those in lower yielding fixed income investments, as their returns may be unable to keep up with rising prices/the cost of living.  While painful, the inflation scenario has resulted in less political and social unrest – and also been followed by periods of economic success in certain instances. (See the U.S. 1970’s and Brazil 1990’s).

I believe the inflation scenario is the one the U.S. and other developed nations will follow – and are already following.  

Inflation, Yes Inflation

I’m skeptical of the “official” inflation statistics.  I believe many consumers are experiencing similar feelings as they see the smaller tubes of toothpaste at the grocery store, and experience the rising cost of Thanksgiving dinner from the prior year.

The chart below is from John William’s Shadow Government Statistics (shadowstats.com).  Simply put, the red line is today’s “official” inflation rate – the CPI-U (consumer price index).  The blue line (ShadowStats SGS Alternate CPI, 1980) is based on the pre-1980 official methodology for computing the CPI-U.  I.E. the blue line is representative of the way inflation/CPI used to be calculated before 1980.

The blue line (consumer price inflation of around 11%) seems to me to be far more representative of what I’m experiencing when I pay for most things.  I believe other Americans are experiencing the same.  I’d also not be surprised to see “real” inflation (as represented by the blue line/pre 1980 methodology) hitting much higher levels in the not so distant future for an extended period of time.

And thus, we help our clients plan accordingly.

As always, I maintain my positive outlook.  That outlook is based on my belief a bear market in one thing is often a bull market in another.

As we enter this critical time – now, more than ever – I believe investors need to focus on their investment strategies. Those readers who are clients are fully aware of the strategies we’re implementing in light of unfolding economic circumstances.  Others may feel free to contact us to learn more.

Sincerely,

Stephan R. Ernharth, JD
Vice President
Ernharth Group
www.ernharth.com

Go to www.ernharth.com/economic-commentaries to read past articles from our Economic Commentary series.