Money Sage (archive)

"Those who forget history are condemned to repeat it." -- George Santayana

Lincoln contended that "You can fool some of the people all of the time and all of the people some of the time, but you can't fool all of the people all of the time." (We hope we got this quote right). As an observer of the "investment world" -- if we were to so dignify the endless and largely meaningless whirl of activity under the Big Tent -- we never cease to be amazed by the inanities which pass for wisdom. We do, from time to time, wonder about the accuracy of the last portion of President Lincoln's dictum.

About no "issue" do we hear more than the universally loathed inflation. (Well, maybe NOT universally loathed; many, in fact do benefit from inflation, and some are aware of same; however, it is necessary to maintain pretenses. Sort of similar to the Marranos in the Spain of the Hapsburgs).

The TRUE RELIGION has, of course, as its primary champion: The FEDERAL RESERVE. The Fed's position is similar to the apellation given to the royal protectors of the Catholic Church during the Middle Ages and early modern period. Thus, the King of France was: His Most Christian Majesty. The King of Spain was: The Catholic King. All sought the papal sanctification: "Defender of the Faith." Sometimes, the bearers of this sacred nomenclature were, in reality, anything BUT defenders of the Faith. Rather, they were devoted to realizing their personal, dynastic, or national ambitions, under the guise of serving the True Religion.

Like all True Believers, the Fed anti-inflation crusaders IGNORE those historically demonstrated facts which contradict their Sacred Vision, and their daily interpretation of the facts.

The FED, we think, is still in the myth-maintenance stage. Behind this myth maintenance, unfortunately, is a significant element of True Belief. These folk are not near-sighted PhD economists or ex-businessmen, but Holy Warriors. They ignore inconvenient facts as well as historically demonstrated relationships when these are inconvenient. Unconsiously, perhaps, many of the FED policymakers seem to practice Stalin's injunction: "When ideology and facts conflict, change the facts." Our FED policymakers -- and their faithful chorus on Wall Street and in the media -- are pretty good at it.

The focus of our attention in this post is the relationship between the FED and Inflation. The current crop of FED policymakers, led by Chairman Bernanke, have trumpeted repeatedly their dependence upon data. This data are comprised of the long series of economic reports produced monthly (or weekly, in some cases) which report on the performance of various sectors of the economy, and, if interpreted skillfully, provide a fairly accurate snapshot of the economy. We have all those smart folks and their smart, Ph.D. holding staffs, studying, analyzing, and interpreting the data for us lesser folk. Sounds good, no?

There is, lamentably, one not-so-small fly in the ointment. All of these beautiful, graphic pictures of the economy are a snapshot OF THE PAST. Their significance, in and of itself, is PURELY OF HISTORICAL INTEREST. They possess ZERO in the way of FORECASTING UTILITY. This basic reality was indirectly acknowledged by the FED chairman a while back when he stated publicly that the FED would utilized the freshest, most recent incoming data. In other words, FED policy would not be based entirely upon ancient history: it would now be based upon modern history as well. History, we would note, is history. It has a certain usefulness ONLY when used in conjunction with known, time-tested forecasting relationships. It is the HISTORY of THESE relationships which should be critical in FED policymaking. In fact, these repeatedly demonstrated relationships are either ignored or demeaned when they do not comport with the INCOMING DATA. The incoming data, after all, has multiple utilities: it serves as an effective CYA mechanism for a central bank unable to forecast, or, unwilling to break with the outdated orthodoxies of the past, or, unwilling to take heat from its fellow foreign central bankers and from its domestic constituencies on Wall Street, in the economics profession, and in the perceptions of the public. It provides cover for those who are inert, fearful, uncertain, unwilling to take a stand which might prove to be unpopular.

In the universe of economic indicators, there are three types: leading indicators, coincident indicators, and lagging indicators. This trinity is recognized by government statisticians and economists, and is reflected in the grouping of indicators issued regularly by the government.
Inflation is generally -- and we would argue correctly -- regarded as THE MOST LAGGING OF ALL INDICATORS. Inflationary inputs take time to work their way through the system and to ultimately manifest their presence. This time can be measured in multiple months. It is well to bear in mind that there is really only ONE significant inflationary input in existence. That input, of course, is the AMOUNT OF MONEY CREATED BY THE CENTRAL BANK ITSELF. The general level of inflation would NOT increase no matter how much INDIVIDUAL commodities or services, no matter how vital, rise in price. It is the central bank which chooses, as a conscious policy decision, to "accommodate" this rise by printing more money, or not to accommodate. If the FED does NOT accommodate, we experience DEFLATION in other prices, and the overall level of prices remains unchanged. (Of course, one consequence of a failure to accommodate could be recession and/or deflation). Indeed, in the current situation, we have heard an endless din about the inflationary rise in oil and other commodity prices. We have heard little about the earlier FED liquidity creation activity during and in the wake of the last recession and its facilitation of the later appearance of a rise in the overall price level. NOR have we heard anything about the consequences of the FED's subsequent decision -- maintained up until very, very recently -- to reduce the excess liquidity it created in the early part of the decade. NOR have we heard anyone note the relationship between the FED's liquidity reduction efforts and the subsequent onset of recessionary conditions AND the DEEPENING DEFLATION IN HOUSE PRICES (soon to be followed by deflation in ramifying consumer sectors UNLESS the FED acts more promptly and more vigorously to re-flate the economy).

Returning to the issue at hand, the FED knows full well that a rise in the statistical measures of inflation is a LAGGING indicator. This rise in inflation was the normally delayed consequence of the easy money policy pursued by the FED up until 18 months ago. The subsequent deflationary consequences of the FED tightening above the 3% overnight rate (to a peak of 5.25%) WILL drive "Inflation" lower and lower as it works its way through the economy.

While one side of the coin of FED policymaking is policy formulation based upon LAGGING indicators like inflation and employment, the other side is IGNORING, and frequently acting CONTRARY TO, the LEADING INDICATORS. In particular, we refer the the structure of the yield curve. As we have noted on several occasions in this blog, the structure of the yield curve is THE MOST RELIABLE LEADING FORECASATER OF THE ECONOMY. If some FED policymakers do not know this, or choose to deny or ignore it, perhaps a refresher course in Economics 101 would be in order. An inversion of the yield curve ALWAYS leads -- by 12-18 months -- a serious slowdown, if not outright recession, of the economy. The current slowdown is RIGHT ON SCHEDULE.

Why then the surprise? Why does the central bank rely upon LAGGING INDICATORS and IGNORE LEADING INDICATORS in policy formulation?

We are confident that you, dear reader, can draw conclusions.