FLASH UPDATE - July 10, 2008

JOHN WILLIAMS’ SHADOW GOVERNMENT STATISTICS

FLASH UPDATE

July 10, 2008

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Spike in Annual Inflation Due Next Week

The Problem Remains Inflation, Not Deflation

Monetary Theory and Limits of Hard Data

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PLEASE NOTE: The regular monthly lull in economic reporting provides an opportunity to address, at subscriber request, issues tied to inflation during a recession as well as issues tied to measuring the key components of monetary theory in terms of money supply, velocity, inflation and the physical volume of economic output. Some of what follows also is a preview of material that will be expanded upon in the upcoming newsletter’s Reporting/Market Focus.

Due to some family matters and travel, the pending full newsletter has been pushed back to around Tuesday or Wednesday of next week (July 15th/16th). Any intervening Flash Updates and Alerts will be posted as needed. All postings will be advised by e-mail.

– Best wishes to all, John Williams

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Recognition Grows of Severe Economic Downturn

Market wisdom suggests that recessions mean low inflation, but as seen with the current circumstance and in at least two historical recessions in the last several decades (specifically the 1973/1975 and 1980 recessions), recessions with significant inflation are a great deal more common than is spun by Wall Street.

As the severity of the current downturn has gained broader recognition, some in the deflationist camp are starting to argue that the underlying fundamentals driving the economy into the ground also will lead to lower prices, actually triggering a deflation. Quite to the contrary, despite deteriorating economic and financial conditions, my outlook remains for rising inflation into 2009 and for a situation that eventually will evolve into a hyperinflationary great depression, as outlined in the April 8th Hyperinflation Special Report.

Slowing economic activity, by its nature, tends to reduce inflation pressures generated by strong economic demand. The current circumstance, however, is one where inflation pressures have been dominated by commodity price distortions (primarily oil) and increasingly a weakening U.S. dollar and surging money supply growth, not from strong economic demand. The current circumstance is somewhat similar to the recession officially clocked from November 1973 to March 1975, which has been the deepest standalone economic contraction, so far, of the post-World War II era. The period was one of soaring oil prices in the wake of the Arab oil embargo, a generally weak dollar and double-digit annual growth in money supply M3.

The severe downturn of 1973/1975 was accompanied by high inflation, per official CPI reporting, with annual inflation averaging 5.2% for the year leading up to the recession, 10.7% during the 16 months of the downturn, and 7.9% in the year following.

The next recession, from January through July 1980, saw even higher inflation, with annual CPI averaging 11.6% in the year leading up to the downturn, 14.3% during the six months of economic contraction, and 11.4% in the 12 months that followed, through to the onset of the next recession.  This was a period that again saw significant oil price increases, near-double-digit annual growth in M3 and mixed dollar pressures.

The 1981/1982 recession saw inflation drop sharply (7.5% average annual inflation, down from 11.4% in the 12 months leading up to the recession, and against 3.2% in the year following the recession), along with declining oil prices and some dollar recovery. The 1990/1991 recession (5.8% average annual inflation) and 2001 recession (2.8% average annual inflation) took place in somewhat milder inflationary environments, or at least under circumstances where reported CPI inflation increasingly was being suppressed by methodological changes (see the SGS Alternate-CPI measure on the Alternate Data tab at www.shadowstats.com).

No Deflation. The U.S. has not seen annual CPI deflation since several periods of minimally lower prices in the late-1940s through the mid-1950s (the latter being outside of a recession). Of the nine official recessions since 1950, none of them were deflationary. The last significant deflation seen in the U.S. was during the Great Depression, thanks to a sharp contraction in the money supply, which, in turn, was due to a large number of bank failures and lost deposits.

As discussed in the February 11th newsletter, and partially repeated here, Federal Reserve Chairman Ben Bernanke addressed deflation risk in a November 21, 2002 speech he gave as a Fed Governor to the National Economists Club entitled "Deflation: Making Sure ‘It’ Doesn’t Happen Here."

Attempting to counter concerns of another Great Depression-style deflation, Bernanke explained in his remarks: "I am confident that the Fed would take whatever means necessary to prevent significant deflation in the United States …"

"Indeed, under a fiat (that is, paper) money system, a government (in practice, the central bank in cooperation with other agencies) should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero."

"Like gold, U.S. dollars have value only to the extent that they are strictly limited in supply. But the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation."

The Fed has the will, the perceived mandate and the ability to create as much new money as is needed to prevent a deflation in the prices of goods and services, as measured by the CPI.

Low Treasury Yields Reflect Demand Distortions, Not Inflationary Expectations. Some will argue that Treasury yields are good indicators of what the markets are expecting in terms of inflation, and that the current negative real (inflation-adjusted) yields are suggesting deflation ahead. That generally would be true, if there were not major distortions in the Treasury market.

The primary distortion in the Treasury market of recent years has been the incredible influx of forced investment from abroad by U.S. trading partners stuck with holding excess dollars from the monstrous U.S. trade deficit. With the bulk of net Treasury issuance absorbed by this foreign investment, yields have been severely depressed by factors other than the market’s inflationary expectations. The Treasury market also recently has been picking up some flight-to-safety from disturbances in the financial system, which has placed further downside pressure on yields. 

Heavy dollar dumping, which will be seen eventually, will tend to eliminate the current market distortions, spiking yields sharply.

Money Supply. The above discussion on inflation and deflation has centered on price changes in goods and services as traditionally measured by the CPI survey. Such, however, is not the same measure of price changes as encompassed in general monetary theory, where the relationship between money supply and inflation commonly is expressed as:

M x V = P x Q

In the above equation, M is the money supply. V is the velocity of money, as measured by the number of times the money supply turns over in a year, relative to the economy as reflected in nominal (not-adjusted for inflation) gross national product (GNP), where V = GNP/M.  GNP is the broadest measure of U.S. economic activity and encompasses the more popularly reported gross domestic product (GDP).

In turn, nominal GNP = P x Q, where P is some measure of GNP deflator (prices/inflation) and Q represents some measure of physical quantity/volume, or a real (inflation-adjusted) GNP, as a measure of economic output.

So, the P or inflation measure here, effectively is the GNP deflator, the change in which is a broader inflation measure than the CPI, since it covers costs of consumption for businesses, government and net exports, in addition to the costs of consumer spending on goods and services. In terms of the other variables,

P = (M x V) / Q

price level equals money supply times velocity, divided by real GNP. Typically, increases in the combination of money supply and velocity, relative to Q (real GNP) result in higher prices. A drop in Q (real GNP), as seen in recessions, also would be inflationary, in theory, if money supply times velocity increased or otherwise did not drop as quickly as real GNP.

There’s More to Money Inflation than Money Supply (i.e. Velocity). The crude equations shown above are meant to provide a sense of some the basics of general monetary theory. Unfortunately putting meaningful hard numbers into the equations is impossible, since none of the variables are measured adequately by extant money supply, inflation or other national income (GNP) data, but the theory can help explain what likely will be happening.

While there is ongoing argument as to what should be included or not included in money supply (M), no measure constructed so far, be it the monetary base or M3, is adequate. For reasons discussed shortly, I prefer to use the broadest measure when assessing the inflation outlook.

Velocity (V) is just the ratio of nominal GNP to the money supply, no better or worse in quality than the numbers used in the numerator and denominator of the calculation. Velocity is important, though. For those looking at the small annual growth in the monetary base — claiming that there is no inflation there — they can be befuddled by a sharp increase in velocity, which tends to happen when interest rates are low, and particularly when inflation -adjusted interest rates are negative, as they are now.  In like manner, declining velocity could provide an offset to the inflation suggested by surging annual growth apparent in M3, but, again, circumstances suggest that increasing, not declining, velocity is more likely at present, which tends to exacerbate the inflation issues suggested by M3 growth.

Current measurements of GNP, both real (Q) and nominal and the related implicit price deflator (P) are virtually worthless, as discussed in various newsletters and the Primer Articles available at www.shadowstats.com. In general, real GNP is meaningfully overstated, the GNP implicit price deflator is meaningfully understated, and the nominal GNP measure does not come close to measuring actual economic activity (i.e. the underground economy).

Accordingly, anyone hoping to calculate actual monetary inflation, derived from the equations used above, faces a very difficult, if not impossible, task, given the current state of the data.

Practical Inflation Forecasting. I have spent the last 25-plus years attempting to generate meaningful and useable forecasts of future economic and inflation activity. Those that have followed my newsletter for some time know that my indicators had been signaling well in advance an inflationary recession, which increasingly appears to be in place in a broad spectrum of economic data (GDP/GNP excepted). One of the top indicators of CPI inflation is money growth. Over time, the broadest measure (M3) has worked as the best inflation predictor.

Although M3 growth has stalled in recent week-to-week and month-to-month reporting, a similar pattern was seen last year, and year-to-year change appears to be holding at about 15.9% as of the June 2008 average. That signals a highly inflationary environment moving into early 2009. These issues will be explored further in the upcoming newsletter.

Week Ahead: The week ahead will see a number of key economic releases for the month of June, with surprises more likely to be on the upside for inflation and on the downside for business activity, than the other way around. On the inflation front, PPI (due Tuesday, July 15th) and the CPI (due Wednesday, July 16th) are expected to show monthly gains of 1.3% and 0.7%, respectively (briefing.com). Shifting seasonal factors and underlying fundamentals would favor upside surprises, the Fed’s systemic-stability needs would favor consensus or something weaker.

From the standpoint of the CPI, year-to-year annual inflation will continue its upturn in June 2008 reporting, dependent on the seasonally-adjusted monthly gain exceeding the 0.26% monthly increase seen in June 2007, which appears quite likely. The difference would directly add to or subtract from May’s annual inflation rate of 4.18%, with a consensus gain of 0.7% for June pushing the annual inflation rate to about 4.6%, and the real 30-year Treasury-bond yield negative. Such an annual inflation result would be just shy of the last near-term peak in official inflation reporting of 4.7%, seen in September 2005, and within a hair’s breadth of hitting a 17-year high.

On the economic side, retail sales (due Tuesday, July 15th), industrial production (due Wednesday, July 16th) and housing starts (due Thursday, July 17th), all are expected to show small monthly gains. Any gain in retail sales will reflect tax-rebate impact and higher inflation, with monthly and annual gains net of inflation likely to be in contraction. Based on continuing weakness in the components of the June purchasing managers survey and in new orders for durable goods, industrial production should contract month-to-month, quarter-to-quarter and year-to-year. The housing numbers remain volatile, but year-to-year change should remain deep in recession territory.  

Broad Outlook Remains Unchanged. All factors considered, the broad outlook remains for an intensifying inflationary recession and deepening systemic and banking solvency crisis. Near-term market recognition of same and risks for unstable market conditions, however, appear to be intensifying, erratically.

Over the shorter term, any major market displacements likely will follow or be accompanied by intense, broad selling of the U.S. dollar. An increasing flight-to-safety outside of the U.S. dollar also should include flight-to-safety into gold. The gold and currency markets remain subject to extreme near-term volatility and both covert and overt central bank intervention. Over the longer term, U.S. equities, bonds and the greenback should suffer terribly, while gold and silver prices should boom. Full details will be covered in the pending newsletter.