Inflation and your investments: inflation and the business cycle.

Inflation is mainly a monetary phenomenon. This means that inflation is caused mainly by the action and the policies of the central bank. The action of the Fed is crucial in determining the growth of the money supply and the level and trend of interest rates relative to inflation - that is, real interest rates (Fig. 5-2).

Sometimes an international or domestic crisis, like the savings and loans and real estate debacle in the early 1990s, forces the Fed to ease and provide liquidity to cushion the crisis. The careful investor recognizes what is happening if he can observe a sharp increase in the growth of the money supply, accompanied by lower real interest rates. Such conditions happened seven times since 1960, most recently in 1984, in 1989, and in 1995. In all these instances the money supply accelerated from growth levels below 3% to close to 15% as short-term interest rates gradually declined.

It is not unusual under circumstances of crisis that the level of real short-term rates falls at or below the level of inflation. When this happens, it should be interpreted as a sign that the Fed has decided to solve the crisis using an easy monetary policy. A similar situation happened in 1997 during the financial crisis in Asia. The Fed at that time aggressively eased by increasing the growth of the money supply and lowering real short-term interest rates. Those were the years when Thailand, South Korea, Malaysia, and Indonesia attracted capital to their countries by offering cheap labor and guaranteeing fixed exchange rates to the dollar. By doing so, they were eliminating the foreign exchange risk from the hands of foreign investors. The problem was created by the fact that the capital that entered the country was not used to improve the overall conditions of the economies, but was squandered in unproductive projects. Eventually, loans could not be repaid and a financial crisis occurred. Currencies had to be sharply devalued, creating huge losses for the original investors, mainly banks. Because of these crises, the Federal Reserve was compelled to stabilize the international banking system by allowing the money supply to grow more rapidly.

There are times when the economic cycle slows down and the Fed is forced to increase liquidity to raise the growth of the money supply to more normal levels. The ideal growth of the money supply in a non-inflationary environment is close to 5-6%. A protracted period when the growth of the money supply is below this range is likely to cause the economy to grow too slowly and the unemployment rate to rise. On the other hand, a protracted period of growth in the money supply well above 5-6% is likely to stimulate too much economic growth and place pressure on productive resources, creating pronounced inflationary risks. The strong growth in the money supply is an important signal that the business cycle will soon turn around, and economic conditions will improve. Inflationary pressures increase when the growth of the money supply rises to around 10%, the economy is growing at well above potential and real short-term interest rates are low or below their historical average of about 1.4.

In the second half of the 1990s the U.S. experienced high growth in the money supply and robust economic growth with low inflation. The main reason was the high level of real short-term interest rates. High real short-term interest rates above 1.4 suggests the real cost of money was high and provided discipline in the way it was spent or invested. However, the strong growth in the money supply and the strong economy that took place late in the 1990s suggested that inflationary pressures were strong, thus creating a high-risk environment for the financial markets. Because of rising inflationary forces, interest rates moved higher, causing lower growth in the demand for money as business postponed new investments due to higher interest rates. Lower demand for money slows down the expansion of the money supply, which has a negative impact on stock prices. The point is that inflationary pressures eventually have a negative impact on monetary aggregates and stock prices.

In chapter two we examined two measures of inflation - the growth in consumer prices and the growth in producer prices. Consumer prices measure the increase in prices at the consumer level, while producer prices measure changes in prices at the producer level. The cyclical timing of consumer and producer prices is that of a lagging indicator. The difference between producer and consumer prices is that producer prices are more volatile than consumer prices, meaning that they rise faster and decline faster. The main reason producer prices are more volatile than consumer prices is that their change is affected mainly by changes in commodity prices. They are more sensitive than, say, changes in medical costs, changes in housing costs, which are included in consumer prices. But the cyclical turning points of the two inflationary measures are the same. This means that when the economy is too strong and there are inflationary pressures, one should see growth in consumer prices rise, accompanied by higher growth in producer prices. When growth of consumer prices declines, one also should see a decline in the growth of producer prices.

Producer prices do not add additional information to the inflation process. They only confirm that inflation is on the way up or on the way down. It is important to recognize that all the goods at the consumer level and at the producer level - from foods to apparel to medical services - tend to accelerate and decelerate together. Their growth rate may be different, but the cyclical timing is that of the lagging indicators.

Let's see how the process of inflation evolves during a typical business cycle. The risk of inflation arises when the economy is growing very rapidly or real interest rates are low. A strong economy is characterized by intense use of resources and strong demand for money. For instance, during such times it’s quite typical to experience a sharply declining unemployment rate. The reduction of available skilled labor places upward pressure on wages, which tend to grow faster. In these cases, GDP is found to grow well above 2 ½ - 3%.

Declining or low unemployment rates suggest the labor market is becoming tight. Under these conditions wages rise faster. Initially, business can absorb these increases in wages by increasing productivity. However, this can be achieved as long as new capacity can be added and skilled labor is plentiful. But when capacity is close to being fully utilized and labor is difficult to find, productivity begins to slow down. This development places upward pressure on unit labor cost - that is, wages adjusted by productivity.

Another development caused by a strong economy is the increase in demand for raw materials. They are the first prices to rise as an economy grows more rapidly (Fig. 7-1). The increase in these prices can be initially absorbed through process efficiency. The third factor that has an important impact on inflation when the economy is strong is the demand for money. Short-term interest rates are very sensitive to credit demands as raw materials are sensitive to production requirement demands (Fig. 7-2).

Major turning points in commodity prices reflect changes in economic conditions caused by fluctuations in the growth of monetary aggregates. p>The cyclical turning points in commodity and short-term interest rates coincide. The amplitude of the move depends on the level of real short-term interest rates which has preceded them. However, there is a point when increases in raw material costs impact the profitability of businesses. The process can be better visualized by using the logical model tying together leading, coincident and lagging indicators. By using the growth of the money supply as a leading indicator, the growth of the economy as a coincident indicator, and commodities and the change in the producer and consumer prices as lagging indicators, the relationship between these forces can be summarized as follows.

• A peak in the growth of the money supply is followed by
• A peak in the growth of the economy, which is followed by
• A peak in commodities, in the growth of producer and consumer prices, which is followed by
• A trough in the growth of the money supply, which is followed by
• A trough in the growth of the economy, which is followed by
• A trough in commodities, in the growth of producer and consumer prices, which is followed by
• A peak in the growth of the money supply

And the cycle starts all over again.

A strong economy, therefore, causes prices of resources such as labor, raw materials, and money to increase. Initially, business tries to absorb these increases in cost, but eventually profit margins start decreasing. This is the time when corporations need to pass these cost increases on to the consumer. The costs of labor, raw materials, and money represent the cost of running a business, and therefore, their upward trends have a negative impact on profitability.

From the consumers’ viewpoint, rising inflation reduces real income and decreases their purchasing power. Therefore, the reaction of consumers to rising inflation is to decrease the level of spending, causing the economy to slow down.

Because of the negative effect of inflation on profitability, business attempts to cut costs as profitability declines. The implications are a) less borrowing by delaying the implementation of planned projects; b) lower inventories to cut raw material costs; and c) layoff of employees to reduce labor costs.

The outcome of the action of business and consumers is to slow down the economy. This slow down will continue until the causes that initiated it - that is, rising commodities, rising labor costs, and rising interest rates - decline. Only then will lower inflation improve consumers' income and induce them to buy more. On the other hand, lower costs improve business margins, encouraging business to implement those projects that were shelved because of rising costs and lower profitability.

The Federal Reserve has an impact on the inflationary spiral if they keep real short-term interest rates too low and the money supply growing too rapidly for too long. In the typical financial cycle, the growth of the money supply rises from a level below 3% to above 10%, well above the average growth rate of about 6-7%. The fluctuations of the business cycle arise because of the sharp accelerations and decelerations in the money supply. The challenge for the Fed is to keep the growth of the money supply as close as possible to 6-7% and to try to avoid the sharp fluctuations in liquidity which cause the volatility of the business cycle. It is very important for the investor to follow these two parameters of monetary policy to determine what type of inflationary cycle to expect.

(From Chapter 7 of my book Profiting in Bull or Bear Markets. Published also in Mandarin and on sale in China. The book is available at Amazon.com).

George Dagnino, PhD Editor,
The Peter Dag Portfolio.
Since 1977
2009 Market Timer of the Year by Timer Digest
Portfolio manager

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