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The counterintuitive relationship between money growth and inflation

While on the subject of commodities, monetary policy, and inflation, I thought I would update this chart that compares M2 growth (M2 being arguably the best measure of money) and consumer price inflation. What strikes me in this chart is the strong tendency of these two lines to move in opposite directions. For example, M2 growth surged from 1995 through 1999, yet inflation fell; very slow M2 growth from 2004 through 2006 was accompanied by rising inflation; M2 growth plunged in 2009, yet inflation surged.

My explanation for this is that money velocity is what is really at work behind the scenes. M2 is typically called a measure of money supply, but it really is a better measure of money demand. When M2 growth slows, it is because money demand is slowing and money velocity (money velocity being the inverse of money demand) is rising. Rising velocity makes a given amount of money support a higher level of prices. Rising velocity is also indicative of a phenomenon in which people try to reduce their money balances in favor of owning more things, and that is a classic symptom of inflationary psychology.

So the fact that M2 growth has been almost zero over the past six months, and only 2% over the past year is both encouraging and troubling at the same time. That's because it means that the velocity of money has turned up sharply, and that in turn is helping to fuel more spending and higher prices.

Oil production is driven by real oil prices

I offer this chart to illustrate just how much the dollar value of commodities can affect the commodities market. What it shows is that the real price of crude oil (in dollars) has a significant impact on oil production via changes in the number of oil and gas rigs that are operating around the world. There is a long lag involved, of course, between increased oil drilling and actual production (several years I believe), but the response from oil producers to changes in the real price of oil is strong and quite obvious.

For example, note that real prices fell sharply from late 1996 through early 1999. In response, the active rig count started falling in late 1997, dropping fully 52% by mid-1999. Real prices then shot up, and that was followed by an eventual tripling in the number of active drilling rigs by 2008.

There's good news and bad news here. On the one hand it's good to know that the price signal does play an important role in the oil market. With real prices relatively high these days, producers are ramping up the exploration and production efforts and this should keep prices from climbing too high. But on the other hand, erratic monetary policy, to the extent it influences oil and other commodity prices, can result in a real roller-coaster ride for the industry over time. First, prices rise, which then encourages more exploration, which eventually results in increased supply, which then helps prices decline. Lower prices then discourage production, which then results in less supply, which eventually helps prices rise.

We would all be far better off without this tremendous price volatility. This is one reason why the Fed should pay more attention to commodity prices, since I do believe they are quite sensitive to changes in monetary policy, as I tried to point out in yesterday's post. If commodity prices were an important input to monetary policy decision-making, we might have not only less volatile commodity prices, but also lower and more stable inflation.

More evidence of a housing bottom

According to March data released today, U.S. housing starts have risen 30% from their all-time low (April '09). In addition, building permits increased 38% over the same period. And not surprisingly, the Bloomberg index of home builders' stocks bottomed last July and has since risen over 50%. And as I've pointed out before, the prices of home equity-backed securities are rising sharply. If this doesn't add up to a clear picture of a bottoming in the residential construction market, I don't know what would.

To be sure, this "bottom" has taken almost a year to form, which makes it the longest-drawn-out recession bottom since data began to be recorded in 1968. Also, housing starts in the winter months are full of seasonal adjustment factors which may or may not accurately reflect underlying activity. But an increase of 30% in just under a year is pretty impressive nonetheless, and hard to chalk up to seasonal or weather-related vagaries.

With most signs pointing to an end to the worst housing recession in modern history and a clear beginning to a housing recovery, the widespread angst over the homes remaining to be foreclosed and auctioned off seems overdone. The recovery is for real, thank goodness.

The reflationary message of key commodity prices

Here's an interesting chart that puts key commodity prices—gold, crude oil, and industrial commodities—in perspective. I've recalibrated each so that they are equal to 100 as of Jan. 31, 1997. I chose early 1997 as a starting point, because I think that monetary, economic and inflation fundamentals were relatively stable around then. The CPI had been fairly steady at just under 3% for six years. Gold prices had been fairly steady at just under $400 for about 4 years. Industrial metals prices had been fairly steady for 2-3 years. The economy had been growing about 3% a year for 4 years. The dollar had been in a flat trend for 6-7 years.

From 1997 through 2003, we began to see the effects of monetary deflation, as the Fed tightened policy aggressively in an attempt to slow what was perceived to be an "overheating" economy. Commodities fell across the board during that period. From 2003 on, we saw the effects of monetary reflation, as the Fed responded to the deflation it had previously generated by keeping interest rates low for an "extended period." Commodity prices rose across the board during that period, not surprisingly. Then came the panic collapse of 2008, when the prices of almost everything declined as global demand evaporated But since then monetary policy has reverted to being very accommodative, demand and confidence have come back, and commodity prices are once again on the rise.

One thing about this chart really stands out: these key commodity prices have essentially tripled in the past 13 years. That works out to almost 9% inflation per year on average. Another interesting observation: gold prices and crude oil prices have risen by almost the same exact amount over this period. In addition, the ratio of gold and crude oil prices today (13 barrels per ounce of gold) is not too far off its average (17.8) for the past 50 years.

Message: these prices tend to move together over time, even though they are very distinct commodities. Gold has an intrinsic value derived from its beauty and durability; crude oil's value is purely as a source of energy; industrial metals are key inputs to most industrial processes and by extension, to economic growth in general. That they are all on the rise is a strong indication that monetary policy is increasing inflation pressures throughout the economy.

Exports continue to grow

Another update of a chart I first showed one year ago. Data on outgoing container shipments from the Ports of Los Angeles and Long Beach (which account for a about 40% of U.S. container traffic) show continued growth in export activity, at least through the end of last month. This data is a a reasonably good and timely proxy for the growth of US exports, which are reported with a lag. Export growth feeds directly into GDP, and it is also a measure of how strong the global economy is. From the looks of things, all systems are go. Los Angeles container shipments have rebounded about 50% from their late-2008 lows, and have almost returned to the highs of early 2008. More V-shaped recovery signs; sorry if this is getting to be a bit boring.

Global industrial production continues to expand

An update to an oft-featured chart. In the 12 months ended Feb. '10, Japanese industrial production rose 31%! U.S. industrial production is up 6% from its June '09 low, and has risen at a 6% annual rate in the past six months. Eurozone industrial production is up at a 11.5% annual rate in the six months ended Feb. '10. While the U.S. seems like the laggard based on these numbers, it is also the case that production never fell as much here as it did there. Taken together, these numbers all point to a substantial recovery from recession lows. All signs point to a continued global recovery, and that means more good news in the months to come.

Inflation at the consumer level subsides

Inflation at the consumer level has turned out to be less than I have been expecting. Indeed, over the past three months the CPI is up only 0.9% at an annual rate, and the core CPI is actually down 0.18% at an annual rate. Much of the decline in inflation can be traced to "Owner's Equivalent Rent," the BLS's estimate of how much a homeowner would be paying if he were renting his home. OER is roughly unchanged over the past year, thanks to the depressed housing market. Abstracting from this, as Brian Wesbury points out, we find that "cash inflation" is up 3.2% over the past year.

I agree with Brian that sooner or later we will see CPI inflation moving higher. The CPI is the last place that true inflation trends will show up, because of the way it's constructed and because inflation at the consumer level is very "sticky." Wages don't change much or very fast in response to changing monetary policy, but gold prices, for example, can change on a dime. It can take years for a loss in the dollar's purchasing power to find it's way through the maze of the U.S. economy and through labor contracts. I think it makes a lot more sense to watch the leading indicators of inflation than it does to watch the official measures of inflation.

Sensitive prices that are set in real-time by the market are where the action is. On that score, we have the following evidence which points to higher, not lower inflation: 1) the dollar is weak against most other currencies, having lost one-third of its value in the past 8 years, 2) gold prices have risen 350% since 2001, and are within inches of their all-time highs, 3) industrial commodity prices are up strongly across the board, 4) oil prices have doubled in the past 16 months, 5) real estate prices have bottomed and are now rising in some areas, 6) short-term real interest rates are negative, meaning that effective borrowing costs are unusually low, 7) money velocity is on the rise, which effectively amplifies the Fed's extremely accommodative policy stance, and 8) the yield curve is extremely steep, a classic sign of easy money. I believe that these are all leading indicators of a coming acceleration in inflation at the consumer level that will likely unfold over the next year or so. You can't wait for the CPI to go up before realizing that inflation is a problem.

Retail sales surge

Retail sales have recovered quite nicely in the past year. As for the shape of the recovery, I think the bottom chart says it best: that's a V if I've ever seen one. No matter you slice and dice the retail sales numbers (e.g., ex-autos, or inflation-adjusted), the results are strong, and a whole lot better than the market expected just one year ago. However, sales still need to recover by another 10% or so before they catch back up to where they would have been absent the financial panic of 2008.

Skeptics will say that sales are up in large part thanks to stimulus spending, but I don't buy that. Stimulus spending, when viewed from a supply-side perspective, just takes money from one person's pocket and puts it in another's. It doesn't create new demand. Even some supply-siders will look at these numbers with some skepticism: How can demand have recovered so strongly without any meaningful growth in jobs?

I think that the recovery we see in these numbers is a function of monetary velocity. (See related posts here.) Consumers shut down their spending in late 2008 due to the huge panic and uncertainty surrounding what appeared to be a global financial crisis that would lead to massive bankruptcies and depression. The demand for money rose sharply as a result. Now that money is getting spent again; money that was stored up is once again flowing into the economy. It was a panic-driven recession, and once the panic subsided and people saw that they economy was going to survive largely intact, they ramped up their spending. This is an unusual recovery since this time a resurgence in demand is preceding a resurgence in jobs.

Once the rising money velocity story plays itself out (say, by early next year), we will probably see the pace of recovery slow back down. Growth from that point will be more a function of new investment and jobs creation than anything else. It might prove to be tough sledding, however, if tax rates rise as expected. But that's tomorrow's concern. For the moment it's just very nice to be getting back to some semblance of normality.

The dollar is still very weak

This is a chart of the Fed's measure of the dollar's strength vs. a large basket of other currencies and adjusted for inflation differentials. I think this is one of the best dollar indices available. As it shows, as of the end of February the dollar was only slightly higher (about 3-4%) than its all-time lows. This, despite the mountains of concerns that have supposedly arisen over the risk that Greek indebtedness could seriously threaten the future existence of the Euro. This is more evidence to back up the assertion in my previous post that market pricing still reveals relatively high levels of concern about the future of the U.S. economy.

Credit spreads reflect substantial progress but room for more

Here are two different looks at credit spreads. The top chart shows credit default spreads over the past few years, and the bottom chart shows corporate spreads (investment grade and high yield) going back over 20 years. The message of both charts is the same: credit spreads have narrowed significantly since the end of 2008, a clear reflection of dramatic improvement in the economic outlook; but spreads are still a lot higher than they tend to be during periods of relative economic tranquility.

This fits nicely with the thesis I have been fleshing out since late 2008. Markets were literally terrified in late 2008 and early 2009, consumed by fears of a global financial meltdown and a deep and lasting depression and deflation. This fear was sparked by the realization that the subprime crisis had morphed into a massively destructive force that culminated in the Lehman bankruptcy and the mad dash by governments all over the world to shore up their financial systems and economies with previously-unheard-of stimulus measures.

Fears were multiplied by the Obama/Pelosi/Reid  $787 billion faux-stimulus budget which ushered in new visions of expansionary government and massive hikes in future tax burdens. Even as the market reached the pinnacle of its fears in early March of last year, I continued to believe that the economy was well on the way to healing itself, despite the headwinds of out-of-control fiscal policy and massively accommodative (and potentially hyperinflationary) monetary policy, and that the recession would end by mid-year. I pointed to declining swap spreads in October and November of '08 as the leading indicator of this improvement, which were then joined by rising commodity prices and a steeper yield curve.

By now it's pretty clear to most (though the NBER is still debating whether or not the recession has officially passed) that the economy is growing. In the space of just one year the debate has shifted from how deep and long the depression was likely to be to how weak or strong or durable the recovery is likely to be. The market was priced to Armageddon, and instead we got a recovery; that alone is enough to justify the 77% rise in the S&P 500 in the past 13 months. But the market is still not prepared to abandon its fears (e.g., of a double-dip recession, or a "new normal" recovery with meager, 2-3% growth and very high European-style unemployment for as far as the eye can see). The market is still demanding a substantial risk premium, in the form or credit spreads that are still historically high, implied volatility that is still historically high, PE ratios (using NIPA after-tax corporate profits) that are still historically low, and Treasury yields that are still historically very low.

The market is still very worried, and with good reason: the economy may be doing better than expected, but we are not out of the woods yet.

The Federal Reserve has more than doubled the monetary base since the financial panic set in, with enough excess reserves now in the banking system to potentially cause hyperinflation and the collapse of the dollar. With no move yet to drain reserves, the best the Fed can do to reassure the world is to lay out a plan to fully drain excess reserves within the next 5 years. The amount of monetary uncertainty this poses is nevertheless so great and so unprecedented that it is difficult for mere mortals to comprehend.

U.S. fiscal policy is out of control, with Congress effectively having abandoned all pretense at living within a budget. Unfunded liabilities of the healthcare, social security, and public sector pension systems are so large as to be clearly unsustainable, yet no one in government has proposed even the beginnings of a solution.

What is holding everything together so far is the U.S. economy's inherent dynamism, its oft-demonstrated ability to forge ahead despite great adversity, and the accumulating V-signs of recovery in many sectors (but not all, to be sure) of the economy. Just as important, but often overlooked, is the political dimension of our fiscal and monetary problems. There have been some seismic shifts in the political landscape in the past year (e.g., the rise of the Tea Party, the election of Scott Brown in MA, and polls that show a majority of Americans favor repealing the healthcare bill) that augur well for a dramatic shift in the balance of power in Congress come November.

If we do indeed see a major political shift take hold, and if it leads to measures that effectively restrain the growth of government and minimize the risk of higher tax burdens, then I think the there is a lot of room for improvement in a number of areas: tighter credit spreads, higher PE ratios, and lower implied volatility. I also think that progress on these fronts would most likely come hand in hand with higher Treasury yields and higher mortgage rates. I'm encouraged, and I remain optimistic for the future.

The commodity V-boom (2)

This may be the most V-shaped recovery of any I've seen of late. It's an index of the prices of some relatively obscure commodities (hides, rubber, tallow, plywood, and red oak) that are included in the larger Journal of Commerce index. Now, I would argue strongly that these commodities are simply not the object of speculators' affection. If I'm wrong, please point me to data which show that speculators are gobbling up tons of this stuff and storing it in massive warehouses around the world. There's a very thinly traded futures contract for rubber, but the fact is that none of these commodities have an easy way for speculators to accumulate large positions in anticipation of price increases. The inescapable conclusion here is that prices are up (and have reached a new all-time high) because global demand is strong. You can't argue with a bullish price signal like this.

Oh, and the last time this index surged was in the latter half of 2003, which just happened to be when the U.S. economy grew at a 5.2% rate.

Federal budget outlook still deeply troubling

Although in the past few months there has been some improvement on the margin in the state of the federal government's budget, the overall picture is still deeply troubling. The improvement comes mostly from a decline in outlays (measured on a rolling 12-month basis), which in turn is a function of the running-off of the crisis-mode spending that occurred in the early months of last year. In addition, in the past few months there has been a slight firming in revenues, which is not surprising given the improvement in the economy since last summer.

But unless big changes are made to the government's spending plans, we are likely to see spending rise back up to 25% or more of GDP in the years to come, especially if healthcare reform is implemented. In an optimistic scenario in which the economy continues to post growth of 3-4% per year, revenues could move back up to 18% of GDP, but that would still leave a deficit of 7-10% of GDP. The deficit over the past 12 months is just under $1.4 trillion, and even "optimistic" numbers such as these would yield annual deficits of $1.1 to $1.7 trillion two years from now.

Thus, our debt to GDP ratio is on track for 100% within the foreseeable future, with the lion's share of the deterioration coming from government spending fueled mainly by transfer payments and entitlement programs. We will be passing on a huge debt to future generations with nothing much to show for it save a growing and cancerous culture of dependency. In a best-case scenario, this will mean a substantially slower trend rate of growth in the future, and lower living standards for most of us than would otherwise have been possible.

The prospect of trillion-dollar deficits is already driving calls for higher taxes on the rich, but that has limited potential to solve the problem since the rich are already paying most of the income taxes these days. The only way to generate a significant increase in revenue is with a VAT tax, such as is being proposed by Paul Volcker, that would land squarely on the shoulders of the middle class.

In the meantime, the prospect of higher income taxes next year is probably helping to drive the improvement in the economy and in the budget situation this year. That's because people have a powerful incentive to accelerate the recognition of income and capital gains to take advantage of today's lower rates. This positive dynamic has its cost, of course, and that will be seen next year in the form of slower income growth and reduced capital gains realizations. (This reminds me that the capital gains tax is the only tax you can legally avoid, simply by not selling whatever you hold at a gain.)

We have seen this dynamic happen several times in the past, as the above chart shows. Prior to the scheduled increase in capital gains taxes in 1987, capital gains realizations surged in 1986, only to collapse once the higher rates kicked in. Conversely, the reduction in the capital gains tax rate in the late 1990s produced a surge in capital gains realizations in subsequent years. Yet despite the abundant evidence that changes in tax rates have profound effects on people's tax strategies and their incentive to work and invest, OMB routinely projects (and politicians happily agree) that higher tax rates will always produce higher tax revenues, and vice versa. Unfortunately it just ain't so: higher tax rates next year could well lead to an even worse budget situation.

Where does this leave us? It's my hope and expectation that this budget picture is ugly enough to grab the electorate's attention. That attention will become laser-focused by the emerging discussion of the need to close an enormous budget gap with hugely higher taxes. With a little luck the electorate will decide we are on an unsustainable path (i.e., too much spending) and vote for change of the positive variety (i.e., less spending). So even though the outlook is deeply troubling, there is still plenty of reason to be optimistic about the future.