Rogue Missives
Rogue Missives
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The Death of Inflation? "In the wider sweep of history, the long period of perpetually rising prices experienced throughout the west since the Second World War, and which we have all taken for granted, is an aberration." -- Roger Bootle, economist What if the economy underwent a fundamental shift, a revolution even, and no one noticed? Policy makers would be stuck fighting the last war even though the enemy had already given up. Investors of all stripes would be making decisions to buy and sell homes, stocks, and currencies based on assumptions that no longer held true. At every turn, poor decisions would lead to squandered opportunities and mismanaged resources since it's ultimately only our assumptions about the future that can truly guide our actions in the here and now. Unfortunately, we tend to know the future only by way of our experience of the past. But what if the future marks a genuine break with that past? In The Death of Inflation (Nicholas Brealey Publishing, 1996), Roger Bootle argues that all of us need to rethink our most basic assumptions about economic life. That's because new structural changes in the global economy mean that in the developed countries of the West, the days of steadily rising prices are simply gone, perhaps for good. And the death of inflation has opened up both new opportunities and new problems, many of which are quite foreign to all of us reared in inflationary times. Bootle, it must be said, is no nut. As the chief economist at the HSBC group (the parent company of the United Kingdom's Midland Bank) and a visiting professor at the Manchester Business School, his pedigree is a first rate mixture of academia and commerce. But his quietly incendiary book, written for the intelligent general reader, turns conventional wisdom on its head. To understand why his argument is worth considering, we need to look at that conventional wisdom and how the past year has presented new economic puzzles that Bootle seems peculiarly capable of explaining. Considering he completed the manuscript in January 1996, his book can seem like a remarkably accurate crystal ball into a future we are already living but have scarcely imagined.
GREENSPAN AND THE CONVENTIONAL WISDOM When Alan Greenspan speaks, the markets listen. The reason is quite simple. As Chairman of the Federal Reserve, Greenspan has considerable power in setting the Federal Funds rate, or the rate at which the Fed will lend money to member banks. The Fed Funds rate, in turn, has an enormous and nearly immediate impact on what interest rates consumers and businesses pay for loans. Since lower rates generally encourage borrowers to borrow and higher rates discourage them, the Fed, and Greenspan in particular, has enormous influence on the real economy. To many investors, all of this might seem relatively obtuse and unimportant. Indeed, one need not spend much time trying to divine the course of interest rates or to determine whether the Dow Jones Industrial Average will go up or down in order to be an enormously successful investor. Picking good stocks at good values should prove rewarding in the long run no matter what the Fed does at any given point in time. Yet it's no exaggeration to say that the Fed is the single most important player in the U.S. economy, and thus in the U.S. equities markets. Congress, the President, bond traders, currency traders, and Michael Jordan all have their impact, but Greenspan's effect is particularly strong. If at some point in his two-day "Humphrey Hawkins" appearance before Congress, Greenspan were to hint that interest rates would need to move sharply higher in the coming months, the markets would undoubtedly be treated quite rapidly to that supposedly inevitable and long-overdue 10% correction that pundits like to talk about. The reason, again, is fairly straightforward. Higher interest rates make other investments, even no-risk bank deposits, look more attractive to investors than they previously did. That's especially true since higher interest rates slow the economy and thus inevitably threaten to dampen corporate profits, which are the primary force driving stock prices. What most matters to the Fed is inflation, or rising prices. Inflation is the bete noir that the markets expect the Fed to control. When in November Greenspan worried aloud about "irrational exuberance" in the stock market, he wasn't fretting about stock valuations per se but about how a soaring market can affect the real economy. Fed-thinking involves thinking through a series of presumably connected relationships with the goal being to keep inflation in check because that's the best way to keep the economy healthy For example, rising markets make investors feel rich which can lead to an excess of consumer spending. This can encourage corporations to increase production which, in turn, can push the envelope of existing capacity. Strong demand can lead to increased labor costs through overtime or wage increases fueled by a tight supply of qualified workers. Companies might also be induced to build new factories, pushing up demand and thus prices for labor and materials in other parts of the economy. Such boom times fuel speculation in real estate, running up prices and spurring even further construction from folks looking to take advantage of a hot market. At every turn, a growing economy can grow into an unsustainable boom marked by rising prices. Rising prices eat away at the value of money, creating uncertainties that sometimes lead to still more fevered consumption which may only further fuel inflation. That's because it may become quite rational to spend a fortune for a new car today rather than wait six months and be forced to pay even more in dollars that have been further devalued by inflation. This nightmare straight from the late 1970s is exactly what everyone wants to avoid since they know that the necessary tonic--or at least the one employed by Fed chairman Paul Volcker at the time--is crippingly high interest rates and deep recession. One might say that our society has come to a broad pact that slight increases in interest rates at the first signs of inflation are infinitely preferable to letting things get out of hand. No pain, no gain. Indeed, since the 1970s, fighting inflation has become far more important to the Fed than ensuring "full employment," an ambiguous goal but one nonetheless central to the Fed mission as enunciated in the Humphrey Hawkins Act, which demands Greenspan's semiannual appearance before Congress. Watching the Fed, then, becomes a matter of watching our chief inflation watcher. Greenspan is generally given high marks for his personal aptitude at the task. A spate of recent reports in the financial press paint him as a man with a mastery of statistical minutiae who nonetheless acts ultimately on a kind of highly-developed gut instinct. Yet over the past year, the great surprise to nearly every professional Fed watcher is that Greenspan -- an official inflation hawk -- has not seen enough incipient inflation to actually raise interest rates. The economy keeps expanding, bringing the official unemployment rate down to 5.4%, a level economists in the past decades have assumed would inevitably spark serious inflation. In fact, economists and traders keep waiting for wage and price pressures to heat up, following the presumably foreordained cycle of business expansions. The markets grow tense. Greenspan surveys all he sees, and time after time says, nope, not yet. Truth be told, inflation actually seems to be disappearing from the U.S. economy. Even considering various quirks in the government statistics, America appears to be experiencing something unknown in recent memory: remarkably strong economic growth mixed with declining and arguably negligible inflation. For example, gross domestic product (GNP) rose at a 4.7% annual rate in the fourth quarter of 1996. However, the Consumer Price Index (CPI) rose by just 0.1% in January, the smallest increase since last June and down from the already low 0.3% increase seen in December. Indeed the CPI was up 3% for the past twelve months, with the core rate, which excludes the volatile food and energy sectors, rising merely 2.5% over the same period. Moreover, the recent Boskin Commission report on the CPI argued that the index overstates the real rate of inflation. A recent Wall Street Journal survey of 320 academic economists found that the majority agreed that the CPI overstates inflation by 1%, or possibly more. While some respected economists, such as Morgan Stanley's Stephen S. Roach, foresee inflation rising this year to as high as 3.8%, most see the CPI being held in check. In fact, the real rate of core inflation may be about 1.5% and falling. The key seems to be a strong dollar that is making imports cheap and thus keeping U.S. manufacturers from raising prices domestically. While economists are hardly oblivious to the apparent changes afoot regarding inflation, they don't really seem to believe what they're seeing. One of the verities of American life since World War II, and more particularly, since the runaway inflation triggered by the OPEC oil embargo of the early '70s, is that inflation doesn't just go away. It's as much a fact of life as death. That may explain the ambivalence seen in a recent quarterly survey conducted by the National Association of Business Economists. On the one hand, three quarters of these corporate economists said that "the level of unemployment at which inflation increases is not sharply defined." In recent years, a central tenet held by most economists was that inflation would pick up beyond a certain level of unemployment, often put at about 6%. These economists, then, offered a frank admission that recent history has cast doubt on this assumption, and thus challenged the notion that an economy with 5.4% unemployment will require higher interest rates to ward off inflation. Such a changing perspective helps explain why over half the economists surveyed expect the Fed to keep interest rates where they are over the next six months. On the other hand, these corporate economists are still worried about the threat of inflation. Whereas just 4% said they thought the Fed would ease rates, some 41% predicted rates would be heading higher within the next six months. Such polls suggest that, despite the view that something new is happening in our economy, the professionals who spend their time thinking about inflation, unemployment, and interest rates generally don't believe we're headed for a sea change in our economic life. The old assumptions basically still hold. Inflation remains Public Enemy #1. With the economy so strong, it's far more likely the Fed will need to raise rates rather than lower them next time Greenspan decides to make a move.
THE ZERO INFLATION ERA According to Bootle, nothing could be more wrong. He argues that we are moving into a period of "zero inflation, meaning this to encompass both the world of minimal inflation where the price level creeps up, but ever so slowly, and the world of bounded price instability where it falls as readily as it rises." The problem, he says, is that economists consider the period of rising inflation since World War II as the norm, when in fact, it's highly abnormal in the scope of human history. Looking at price levels in Great Britain over the past seven centuries reveals that less than 3% of the cumulative increase in prices occurred between 1264 and 1940, with 97% of inflation coming in the post war period. Prices in 1932 were actually lower than they had been in 1795. Britain's economic history is only unusual in the length of the historical record. The same pattern generally holds true in the U.S., France, and Germany. What Britain's historical record also reveals is that until the post-war period, prices were as likely to fall as to rise. "During the last 60 years, alone in the whole of history, prices only ever went up." Bootle's argument, then, is that we are actually on the verge of returning to something like normalcy in the realm of inflation, meaning in turn that we need to rethink our assumptions about interest rates since the are set to discount inflation. Bootle's explanation for why this change is occurring is hardly startling. The combined effects of globalization and changes in technology have made markets more competitive. This is true even in the sense that the information revolution now allows currency traders to instantaneously constrain or punish governments that adopt inflationary patterns of government spending. As technology has led to improvements in mass manufacturing, demand for unskilled and semi-skilled employees in the West has also suffered. Many of these jobs, such as in the textile industry, have moved overseas. In the process, displaced workers have increasingly looked for jobs in the service sector, which unions have found more difficult to influence. Moreover, even workers who find jobs in manufacturing are experiencing less job security. The primary increase in productivity over the past decades has come in manufacturing, and workers in this sector have tried to claim the full economic benefits of those gains, meaning that prices have been slow to fall. But service sector employees wanted to keep up with their manufacturing brethren. The result was increasing wage pressure. Now that developing countries have forced manufacturers in the West to cut costs and pass on the price savings to consumers, the general pressure to raise wages has abated. Indeed, Bootle argues that inflation makes consumers less responsive to price increase. Little to no inflation has the opposite effect, constraining price increases. Workers -- who are also consumers -- thus adjust their own perspective in terms of pay increases. This means that in a low-inflation environment, workers are more willing to supply their labor without pushing up prices because their consumption patterns won't be damaged and because they perceive employers as being more price sensitive when it comes to labor. In other words, "[h]igh inflation breeds passivity in the face of price rises, but aggression in the pursuit of pay rises. Low inflation breeds sensitivity in the face of price rises and passivity in the face of 'low' pay rises." The result is that "it will be possible to operate at higher levels of output without igniting inflation than seemed possible when inflation was high." Bootle argues, for example, that the high utilization of manufacturing capacity, which most economists consider inflationary, may be perfectly compatible with low inflation. That's because he envisions a world where the price sensitivity of consumers leads producers to aim for low margins and high volumes. Companies that master this model will be the ones most likely to succeed. Bootle does seem wrong when he claims that brand names will have diminished importance in this new era. Yet, it's easy to see that even a high-margin company like Intel has opted for high volume over even higher margins, with the effect that the price of a powerful computer has gone down even as Intel continues to strain its manufacturing capacity. On the other hand, even the strong Apple brand has been impaled on the sword of high margins. Most importantly, Bootle thinks there is plenty of room for monetary authorities in the West to "aim for higher growth and lower unemployment, without setting off an inflationary upsurge." He calls for lower interest rates since, in an environment of low inflation, nominal rates of 3% may be high in real terms. Indeed, he says the greatest threat to western economies is not inflation but deflation. This is largely because neither monetary authorities such as the Fed nor average consumers are expecting it. For one thing, central bankers can spur economic activity by lowering interest rates. But interest rates cannot go below zero even if prices begin falling. Thus in an economy experiencing deflation, real interest rates can effectively rise, even if the nominal rate is set at zero. Japan, for example, has recently been threatened with deflation as wholesale prices actually fell 7% between 1990 and 1995. The danger in such an environment is that our central device to manage the economy -- a central bank's control of interest rates -- can essentially be lost. The message, then, is that central bankers need to begin thinking about erring on the side of keeping the system sufficiently juiced since the end to the inflation regime will constrain their power to keep an economy rolling. Or consider the more concrete example of buying a home. Consumers have been willing to take on enormous mortgage debt in part because inflation allows them to pay off those loans with debased dollars at a later date. In simple terms, inflation makes owning a home a less expensive prospect because while a mortgage of $400 a month might seem significant when your income is just $15,000 a year, it becomes less burdensome when your salary, rising to keep up with inflation, hits $30,000 or $40,000. Indeed, considering the tax advantages of homeowning, inflation can effectively make the after-tax rate of interest negative. For example, a 6% mortgage in a period of 2% inflation means the real interest rate is 4%. If 40% of mortgage interest is tax deductible, that puts the nominal interest rate after taxes at just 3.6% (60% of 6%) or merely 1.6% after adjusting for inflation. Higher inflation actually makes it cheaper to own a home. With inflation at 8% and nominal rates at 12%, the real rate is 4%. But the 40% deductible reduces the nominal rate to just 7.2% (60% of 12%). With inflation at 8%, the real interest rate on a home loan is actually negative. In a zero inflation era, Bootle predicts that homeowning will become a less attractive investment, which in turn will suck out the periodic speculation that drives the market for residential real estate. Population demographics may allow homes to hold their value or even increase slightly, but their value isn't likely to rise dramatically in real terms, as has consistently been the case over the past five decades. Moreover, consumers will have to spend less of their income upfront on a mortgage, but monthly payments will no longer decline in real terms over the life of a loan. That means younger people will have more money, which will go toward increased consumption or increased savings. And middle-aged people will progressively have less to spend, since inflation won't be helping reduce their mortgage bill in real terms. Exactly how these forces will play out remains to be seen. But Bootle suggests that younger consumers may be encouraged to put more money to work in the stock market since owning a home will no longer cost as much upfront nor produce the long-term return on savings that it has for so long now. At the same time that housing, retailing, and other consumer businesses are hurt by the more competitive, low inflation environment, so too will the retail financial services industry. The reason is simple: management fees of 1% or more will begin to look unattractive in light of lower nominal returns. Of course, a very different scenario will be playing out in the developing countries in Asia, South and Central America, and Eastern Europe. Their exceptional growth will go hand in hand with high inflation rates. Bootle's vision doesn't necessarily mean that capitalism will be any less brutal than it has been. Indeed, unskilled labor in the West will continue to lose out, likely exacerbating income disparity. But what is clear is that a thorough rethinking of our economic assumptions is necessary if the West is to adjust to such a new zero era. The most obvious place to begin would be for Greenspan and other central bankers to begin a move toward still lower interest rates. It's hard to tell if Greenspan is actually ready to test the inflation waters with more growth. What's curious, however, is that his reluctance to raise rates, even in light of pressure from others within the Federal Reserve system, suggests that his gut instincts are picking up on the economic changes that so concern Bootle. At any rate, The Death of Inflation offers an instructive and responsible vision of a surprisingly possible future for which none of us seem quite prepared.
--Louis Corrigan (RgeSeymour) |
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