DISCLAIMER: THE FOLLOWING "The Real Debate: Inflation or No Inflation in 2005" CONTAINS STRONG OPINIONS WHICH ARE NOT A REFLECTION OF THE OPINIONS OF FOX NEWS AND SHOULD NOT BE RELIED UPON AS INVESTMENT ADVICE WHEN MAKING PERSONAL INVESTMENT DECISIONS. IT IS FOX NEWS' POLICY THAT CONTRIBUTORS DISCLOSE POSITIONS THEY HOLD IN STOCKS THEY DISCUSS, THOUGH POSITIONS MAY CHANGE. READERS OF "The Real Debate: Inflation or No Inflation in 2005" MUST TAKE RESPONSIBILITY FOR THEIR OWN INVESTMENT DECISIONS.
At this juncture of the recovery, one can argue endlessly about a number of investment issues.
• Is this one-year move in the market a dead cat bounce, or cyclical bull market within the greater context of a secular (long-term) bear market, a la 1968-1982, or 1929-1940?
My answer is "who cares?" Let the 50-day/200-day moving average of the S&P 500 tell you when this "whatever" market is done. In the meantime, keep making money by owning great secular growth stocks.
• Will interest rates start to be jacked up in June?
My answer: Not possible. See next question.
• Is all the monetary stimulus in the U.S. system sowing the seeds of a spike up in inflation (search) in early 2005 to 2 percent+ from 1.2 percent today?
Bingo! Now we have a discussion worth having.
The Economics Smackdown
You may not have liked economics in college, but we about to enter the Economics Smackdown of 2004-2005 and you'd better pay attention now. If you are long stocks and long longer-term bonds, your wealth lies in the balance of this debate.
Why? Because interest rates follow inflation rates over 92 percent of the time -- check the Bureau of Economic Analysis charts if you care to. It's not too much GDP growth that cooks up interest rates, it's higher rates of inflation.
No inflation, no major interest rate increases anytime soon -- even in an expanding economy.
No big up-tick in interest rates? You'll see nice returns from equities growing their earnings faster than the overall economy.
In other words, your stocks go UP from here.
So think of inflation forecasting as the Tony Montana School of Economics: the “first you get the money, then you get the power, THEN you get the women” line from "Scarface." You DON'T know the line? What were you doing in the '80s?
Only here’s Mr. Montana would teach:
First you get the inflation rise. Then you get the interest rate rise. Then you get the hell out of economically and interest rate sensitive stocks and long-term bonds and switch to equities and investments that benefit from rising inflation (i.e. gold, commodities, inflation-adjusted treasuries and variable rate bonds).
It is the specter of rising inflation rates -- not this convulsive fear of the Fed raising short-term interest rate targets -- that you and I should to obsess over. Inflation is like kryptonite for stocks. And for the next few quarters, you are going to watch a battle royal in the marketplace between the monetarists and the supply-siders. You need to understand this battle to make the right investment decisions this year and next.
If you believe the 1976 Nobel economics laureate Milton Friedman (search), inflation is a monetary phenomenon, not "too much demand for not enough goods." Keynesian economists (who are advocates of the work of John Maynard Keynes) say forget monetary growth, it's too much demand that creates inflation.
You see, there are two types of inflation:
Cost-push inflation occurs when a company's costs rise and they have to put their prices up to compensate. Cost increases may happen because wages have gone up or because raw material prices have increased. With excess capacity and worldwide competition these days in most markets, cost-push inflation has been absorbed by manufacturers who have used higher rates of productivity to offset rising raw materials costs.
Now if there is an excess level of demand in the economy, this will tend to cause prices to rise. This type of inflation is called demand-pull inflation and is argued by Keynes' boys to be the main causes of inflation.
This is the "fear of too much growth" camp. They want to see orderly growth in the economy, but not too much. Whatever that is.
Classics Never Go Out of Style
Let's go to the classical view of inflation: the Quantity Theory of Money. This theory is MV = PT where:
• M is the amount of money in circulation
• V is the velocity of circulation of that money
• P is the average price level and
• T is the number of transactions taking place
Keynes argued that increases in the money supply (M) would NOT inevitably lead to increases in inflation. His major point was that increasing money may instead lead to a decrease in the velocity (V) of money circulation.
In other words, the average speed of circulation of money would fall because there was more of it around. Less velocity of circulation, less demand. Less demand, less cost-pull in the economy -- ergo no inflation.
Friedman came to another conclusion: that V and T were both independently determined in the long run. His conclusion was if the money supply grew faster than the underlying growth rate of output, there would be inflation.
In other words, increases in the money supply would lead to inflation. The message was simple -- control the money supply to control inflation
My advice? Combine both approaches.
Let's look to industrial capacity, now running at 76 percent. Until we get to 81-82 percent, pricing power for most manufactured goods will remain balanced. High levels of industrial capacity use signal too much demand in the economy vis-à-vis production capacity. More demand not met by similar rates of productivity growth and sidelined labor that can return to the work force gets us ... cost-pull inflation. And it would be immediately fought by the Fed with BIG interest rate hikes, a la 1994.
So let's look for productivity rates and people seeking employment. We should see productivity rates fall a little into 2004, and this will take out some of the pricing buffer in our economy. Falling productivity rates will also mean employment rates as measured by the payroll surveys will spike upwards, but much of that payroll should come from the employees on the sidelines not actively looking for work.
The inflation scenario I forecast in 2005 will come from these indicators:
• End-demand for goods and services in the U.S.
• Job creation as a measurement of end-demand
• Pricing power for those goods and services providers
• The price of Treasury inflation-protection securities (TIPS)
Right now the most worrisome inflation indicator I see is the implied rate of inflation priced into TIPS. From an implied rate of 1.5 percent three months ago, the rate of inflation implied by the five-year TIPS bonds is now 2.3 percent. The bond market is telling us that inflation is going to be higher in 2005 than it is today -- that is definitely a concern.
You can figure what the bond market's inflation expectation is by comparing the average maturity of a 10-year Treasury with a 10-year TIPS. The difference today -- also known as the breakeven point -- is 2.3 percent. That's a big move up from 1.6 percent.
We'll monitor this Economics Smackdown for you, but just remember it's INFLATION you need to worry about -- not interest rates.