Fighting Deflation at Point Blank Range

John Mauldin | Thoughts from the Frontline
December 6, 2002

My letter last week on Fed Governor Bernanke's speech drew a great deal of comment from readers. I still read every one of your letters to me, even though I cannot answer them all.

Bill Gross of Pimco fame also weighed in on the implications of the speech this last week. Because I think this speech represents a defining moment for investors and our economy, we are going to touch upon points of it again, but from a different angle. I shall attempt to show why I disagree with some of the conclusions made by Gross.

There are some analysts whom I read regularly. I find their writing and logic clear, and as I learn more about their thinking, I find myself holding imaginary dialogues with them. It is one of my little eccentricities of how I process information. When they write something with which I disagree, I am forced to review my own logic much more rigorously. Sometimes I change my opinions, and at other times I don't. But the process hopefully makes me a better analyst as I come to more fully understand why I believe what I believe.

Gross sits on top of the largest pile of bonds in the world. He is acknowledged as one of the true experts on bonds. He also writes a monthly column (at www.pimco.com), which generally shows up the first few days of each month. One of the reasons I look forward to the first of the month is that I shall again get to read a new Gross column. Indeed, my one real complaint with Gross is that he only writes once a month. When I find myself in disagreement with Gross, I force myself to think through my own positions.

This month, I found myself nodding in agreement with him until I got to the end of his column. He concludes that "the salad days for treasury bonds are over." Let's quickly review where we agree, then move on to the (hopefully) equally instructive points of disagreement.

He starts with a conversation he holds with his personal genie. (I take some comfort in the fact that I am not the only analyst who has extended conversations with imaginary friends.) With one of his three traditional questions, he asks his bond market genie what are the two most important questions to ask as we head into 2003.

Before giving us the two questions, the voluble genie (with a distinctive Gross accent) launches into an essay of current economic conditions. Last month, the genie told Gross, you "have previously suggested that high corporate and individual debt levels, combined with the acceleration of globalization - featuring low cost powerhouse China - have fostered this near deflationary environment. You have, however, cautioned that central banks and governments would not sit idly by. A 200 billion dollar fiscal deficit and 1% short rates in the U.S. are ample proof of that. Still the government's pixie dust seems to have lost a bit of its magic..... Perhaps deflation is inevitable."

"But things change - even over a few months time. Since you last wrote about this struggle in October, Greenspan dropped short yields by 50 basis points to protect against a continuing "soft patch" in the economy (read: "potential deflationary downdraft"), and changed the Fed's future bias to neutral. In addition, Fed Governor Bernanke came forward with a Greenspan authorized, coolly calculated speech before the National Economists Club entitled "Deflation: Making Sure 'IT' Doesn't Happen Here." These two events are near seminal. First of all, even if Mr. Greenspan's bias wasn't officially "neutral," there isn't any more room to ease short interest rates."

The genie then proceeds to explain that at 75 basis points of yield and 75 basis points of expenses, money market funds would be close to break even. Mom and Pop Retiree would not be happy if the Fed cuts rates again, as their money market funds would now be paying zero. Further, "...most consumer durables are being bought and financed at 0% already. Not only cars, but TVs, appliances, and DVDs are sold at no cost 0% financing. All of this must tell you that short rates are going no lower."

Here I must take slight exception with Gross's bond genie. There is still room to lower short term rates. First of all, Mom and Pop Retiree were not happy with money market rates when they were only 2%. Now they are 1%. Their displeasure did not keep the Fed from cutting rates a few weeks ago, and I doubt it will in the future. Greenspan is not running for office in Florida. Further, there was plenty of "0%" financing before the last rate cut.

Neither of those two reasons kept them from cutting before, and would not restrain them in the future. I do agree that there is a practical limit to rate cuts, and Gross rightly points out that lowering rates below the effective cost of running a money market fund is probably that limit. The Fed does not want to put $2.4 trillion in money market funds into negative earnings territory. But we are 50 basis points from there, and I don't think the Fed is worried about whether money market fund managers are making the profits they want to make.

That is not to say they will or even should cut, but simply that there is room should they decide to do so, in my opinion.

Here is where Gross and I are in total agreement, and this re-enforces the main point of last week's letter as the genie once again points out: "Secondly, the forcefulness of Bernanke's speech tells observers plenty about the ultimate winner in the battle between inflation and deflation. Avoiding deflation it seems depends not only on appropriate policies, but on the resolve of government authorities and their agencies to implement them.

"I must tell you, Bond Man, I believe them. These people may be misguided, their policies might eventually do more harm than good, but I believe them. They will not allow the U.S. economy to deflate as long as the current regime (read: "Greenspan's Fed") is in power."

And now Gross tells us the genie's answer to his request for the two most important questions we can ask:

#1: If the cost of money in the U.S. can't go down, then it must eventually go up, he said. The question to ask is WHEN?

#2: If we won't have deflation then we must eventually have reflation. The question to ask is HOW MUCH?

Of course, the genie then gets tired and disappears, leaving Gross to guess the answers. As for when, he thinks that a more "normal" level for Fed funds would be in the 2% area, "so Greenspan may have the courage to go back up there at some point in late 2003."

How much inflation? "2-3% is desirable. An overshoot, which has been the historical precedent, might at some point give us more."

If Gross is right then you should sell your long government bonds today, which is why he thinks the "salad days" for government bonds are over. He suggests corporate bonds, emerging market bonds and TIPS. 4-5% annual total returns for bonds AT BEST over the next few years should be expected. "The Fed and Congress will make sure of that by conquering deflation, promoting inflation, and perhaps in the process creating even more financial instability than we have seen in recent years."

I agree with that last quote, especially the part about creating financial instability. Where I part ways with Gross is his assessment that Greenspan may have the courage to raise rates in late 2003. It is not a matter of courage. It is a matter of ability.

Bernanke's speech used the phrase "stimulate demand" on numerous occasions. The Fed is absolutely committed to fighting deflation while at the same time "stimulating demand" to keep the economy out of recession.

What could precipitate an environment where Greenspan could raise rates? Either the economy rebounds strongly in 2003, enough so that raising interest rates will prove no significant deterrent to growth, or inflation actually starts to get out of control in just the next 10 months, forcing the Fed to make a move to control 4% or more inflation.

Let's look at both possibilities. First, is the economy likely to be growing substantially in late 2003? You can make the argument that it will because of the large stimulus being provided by both the Fed and the government. It is likely we will see more tax cuts, increased government spending and a very accommodative Fed. These are all calculated to give us a growing economy.

Tax cuts put more money in the pocketbooks of taxpayers, which presumably allows them to spend or save more, which is a good thing. Federal spending employs people and puts money into the economy. Lower interest rates, especially lower mortgage rates, allow people to pay less for debt or to borrow more to spend on goods and services. Lower interest rate costs also mean businesses pay less for debt (thus more potential profit) and its costs less to make new investment. These are the traditional tools for stimulation.

If this were 1991, I would have to agree that the results of the massive stimulation we are now seeing would be a powerful surge in growth. But things are quite different now.

I presented a great deal of good news for the economy last week, but noted that it is balanced with negative news. While the economy is not rolling over, neither is it getting ready to burst into the stratosphere, despite Kudlow and Cramer's optimistic cheerleading.

Fighting Deflation at Point Blank Range

First, as Stephen Roach continually and adeptly points out, "Guns are blazing on the anti-deflation front.....The full force of the global policy arsenal now seems aimed at arresting deflation. And that's very good news.....The bad news is that there's no guarantee the medicine will work. Policy traction is most difficult to achieve at low levels of inflation and nominal interest rates. Just ask Japan. In the case of the US economy, stabilization policies typically work their charm on three sectors - consumer durables, homebuilding, and business capital spending. With all three sectors having gone to excess in recent years, any response to policy stimulus could be surprisingly muted....History tells us that deflationary remedies must be administered early and aggressively. Only time will tell if it already isn't too late."

Let's look at why he may be right. American families used mortgage refinancing to pull cash from their homes at a record 12.2% annual pace in the third quarter, and household debt climbed at a 9.6% pace, substantially faster than in the hottest years of the 1990s boom. (LA Times) While this partially helped fuel a 4% GDP growth in the third quarter, it doesn't seem to be doing much for this quarter.

We may be coming to the end of the mortgage financing merry-go-round. "Homeowners will take out $751 billion in home loans next year to repay older, costlier debt, often taking cash out of equity in their homes, the Mortgage Bankers Association estimated. That would be just over half the projected record of $1.4 trillion this year and down from $1.2 trillion in 2001."

If it takes record re-financing to maintain consumer spending growth, yet by all appearances this will be a weak Christmas (except for Wal-Mart and other discounters), then what does that bode for 2003? If less money is taken out of home equity by consumers in 2003, where is the impetus/stimulus for growth coming from?

Home prices showed just a 0.84% rise in the third quarter (Dow Jones Newswire). While US factory orders rose 1.5% last month, the overall ISM manufacturing index still is not growing. Capacity utilization is still hovering in the mid-70's, a very poor showing. While business spending does show some signs of improving, it is from a very low level.

I acknowledge that all the stimulus will have an effect, but I think it is far more likely to simply keep us in the mode of the Muddle Through Economy than to propel us back to the future of 4-5% annual growth.

An increase in rates in a slow growth Muddle Through Economy is a prescription for recession. Greenspan will not do that. Read Bernanke's lips.

[Sidebar comment: the Fed realizes that deflation is knocking at the door, and Bernanke (read Greenspan) says they are prepared to fight it out at point blank range, if necessary. The Fed moving their policy stance to "neutral" is smoke screen. If that was the case, then Bernanke would not have made the speech after the rates cuts. The "neutral" move was to keep from spooking the markets. The question in my mind is how will the market react when the Fed either cuts again or invokes some other deflation fighting policy?]

Inflation? What Inflation?

Now let us examine the possibility that inflation comes roaring back. Marshall Auerback gives us a convincing article that shows that the recent rise in inflation is not what it seems (http://www.prudentbear.com/internationalperspective.asp).

Quoting Stephen Perlstein in the Washington Post: "Government statistics show that average prices for products have declined in the past year, including those of cars, clothing, computers, furniture, gasoline and heating oil. So, too, have the prices for services such as telephones, hotel rooms and airplane tickets, even as costs for other services such as health care, housing, education and cable television continued to rise. The broadest measure of prices in the economy shows they rose less than 1 percent during the 12 months that ended in September, the smallest increase in 50 years."

Merrill Lynch economist David Rosenberg "has noted that if it were not for a handful of items that comprise a mere 7 per cent of the CPI - auto insurance premiums (+9.5% y-o-y), tobacco (+9.2% y-o-y), hospital services (+9.0% y-o-y), and tuition (+6.5% y-o-y), the US inflation rate would already be running below the one per cent level."

Auerbach quotes extensive data to show that corporate profits are sustained by cost-cutting rather than profits from operations. For cost-cutting substitute job lay-offs. This is what contributes to today's "surprise" rise in unemployment to 6% (predicted in this column months ago). It is also why productivity improved. There are fewer workers producing the same amount of goods.

Using a statistic which measures the pricing power of corporations, Auerbach shows that many segments of the US corporate economy are experiencing outright deflation. Notice the sectors above which show large inflation. They are industries which might be called "necessities." You are legally required to purchase auto insurance (and home insurance which is also rising), when you are sick you don't negotiate with the hospital, and addiction to tobacco serves to offset any price rise. Education is considered to be a necessity as well. Each of these can only be serviced by US companies. There is no Chinese product for which to substitute, or hold down, prices in these areas.

In short, there is no incipient inflation in the corporate world, expect for isolated sectors. Granted, these sectors are big when you are buying their products, but with the exception of health care, they are not big employers nor are they exceptionally profitable.

So what is a Fed to do as they are seemingly between a rock and a hard place? I still strongly believe, as I wrote almost two years ago, that Greenspan has raised rates for the last time in his career. They need to fight deflation and still keep from igniting enough inflation that they are forced to raise rates. If mortgage rates are allowed to rise, it will choke off the growth or even the stability of the housing and consumer sectors.

The clue for me is in Bernanke's speech: they are going to try and bring down long term rates (see last week's letter for an explanation of how). They will try to keep the economy moving along through what Greenspan calls a "soft patch" and what I call the Muddle Through Economy, all the while hoping that business spending picks up. They will continue to grow the money supply at the present high rate, but I do not think it will be enough to stimulate inflation, unless they really step up the pace.

If they do that (bring back 4% or more inflation), then long term rates shoot through the roof, which aborts even my Muddle Through Economy. They cannot risk that. If they do, and overshoot, which as Gross notes is typically what happens, then the implications for the economy are very negative. They are, therefore, left with working on the long end of the rate curve.

Can they do it? Interestingly, only a few months ago, Gross himself asserted that he did not think mortgage rates can go much below 5%. His feeling seemed to be that at some point the stimulus from that source would dry up. But that also suggest at one point he felt that rates could drop. He would say that the recent Fed stance has caused him to change his view.

So who is right? Have we seen the lows for interest rates as Gross suggests? Or are we headed lower?

Let me first state that I agree with Gross that inflation is in our future. As for how much, I think it is likely they will overshoot. (Just for the record, I do not think we are in for hyperinflation, as some suggest.) I believe the statements from the Fed accurately reflect their intentions.

The disagreement is as to when the inflation starts. Gross thinks sooner rather than later. I think later rather than sooner. Still, I would caution readers to not bet more than a very modest part of their portfolio on my view of the Fed's likely aggressive action to lower long term rates. It is not altogether clear that just because the Fed attempts to lower long term rates while avoiding deflation that they will be successful.

In the short run, Gross's course of action is probably the safer of the two courses. If he is wrong, you will lose a few points of interest income, and maybe some nice capital gains if you are aggressive. If I am wrong, you could be down a few points in medium term bonds, and more in long term bonds.

If you have been investing in long term bonds since I first wrote about them in 1998, you are up a tidy sum. But you have suffered through a lot of volatility. If you stick with them it is likely you will go through more volatility in the future. I agree with Gross we are nearing the end game in bonds. I just don't think it will be in 2003.

Competitive Currency Devaluations

What could change my scenario (and my opinion)? If the dollar were to drop significantly, this would keep the Fed from having to do a lot of heavy lifting in the fight against deflation.

Bernanke again hinted as much. After disavowing the notion that he would dare suggest what the course of action over at Treasury should be in regards to the strength of the dollar, he then proceeds to make the suggestion and the case that a lower dollar would be just fine with him, thank you very much.

Considering the huge trade deficits, why has the dollar not dropped through the floor? Why has, as Bill Bonner of Daily Reckoning fame notes, the United States been so successful at living off the kindness of strangers? By this, he means that foreign investors are willing to lend America almost $1.5 billion per day to finance our spending habits.

In the past, trade deficits at the percentage level at which we are today have always meant a serious drop in currency values. Yet, we have seen only a modest drop. The Euro is still down 15% from where it was only two years ago, even after rising back to parity as it currently stands. The dollar has gained dramatically against the yen and other Asian currencies.

Stephen Roach argues today that: "In that regard, and in the context of America's massive current-account deficit (an estimated -4.6% of GDP in 2002) and Japan's outsize external surplus (an estimated +3.3% of GDP in 2002), it's hard to argue on the basis of economic fundamentals that the yen "deserves" to fall more than the dollar. Over the long sweep of economic history, current-account adjustments - from deficit to balance - are invariably accommodated by currency depreciation. On that basis, it's only a matter of when - not if - the dollar falls."

And yet, arguing that the yen is "too high" is exactly what Japanese officials are doing. Some openly suggest that the yen should fall to 150-160 from the current 123. It seems to be clear that just as our Fed is committed to fighting deflation, Japanese officials are committed to devaluing the yen. And as I have written about for years, every round of currency devaluation by one Asian country sets off another round of what Greg Weldon calls the competitive currency devaluation raceway.

Rebecca McCaughrin of Morgan Stanley tells us: "Annualized US Treasury data through September confirm that the US is on track to post $518 billion in net aggregate long-term portfolio inflows - net acquisitions by foreign residents of securities in the US less net acquisitions by US residents of securities abroad - more than sufficient to single-handedly cover the estimated $496 billion current account deficit. Net foreign purchases of US securities have held steady thanks to robust demand for US fixed income instruments, with demand for agencies and US Treasuries ramping up in recent months."

Why would foreigners buy dollars, and especially government bonds and t-bills when, as Roach notes, it is only a matter of time before the dollar falls? Especially when you can get far more competitive rates in euros or pound sterling?

The reason is simple. Just like I tell you we as US investors need to act in terms of what our Fed is telling us they are going to do, foreigners are acting in terms of what their central banks are saying and doing. And what foreign central banks say is they intend to weaken their currency in terms of dollars. If you live in most countries of the world, your experience has been that your central bank is quite capable of destroying the value of your currency, so you tend to believe them when they say they intend to keep their currency "competitive." Given the fact the Chinese remnimbi (their currency) is the standard for "competitive" and that the Chinese government has pegged it to the dollar, other countries, specifically Japan, feel they must lower their currency in order for their products to continue to be attractive to US consumers.

Europe alone in the world seems willing to let the euro rise. But remember it started around $1.17 or so only a few years ago. My side bet is that when it gets near that point, there will be calls from all corners of Europe to stop the advance. European businesses are already reeling from competition from Asia, and the continent approaches recession. How much more can the euro rise without affecting their exports?

Will the music stop at some point? History says yes, but as long as the dollar remains the de facto reserve currency of the world, it is not clear when that will be. We can't devalue our currency, as Bernanke suggests, if the rest of the world does not go along. As long as the world remains addicted to the US consumer, and as long as they seem to think the dollar will remain strong relative to their currency, the dollar will not drop significantly.

It could be longer than many dollar bears imagine. And as long as the dollar remains strong, the Fed must find other ways to fight deflation.

The Skunk at the Party

Today I gave the keynote luncheon address at the Eighth Annual National Pension Summit Symposium. The title of my speech was "Getting Absolute Returns in a Secular Bear Market." As I made the case for flat returns in the stock market over the rest of the decade and small returns for bonds, you could see more than a few frowning faces. This was not the encouraging cheerleading that some were used to hearing. Surprising to me, many were quite receptive, and the question and answer session was quite lively. The experience of the past few years has many pension executives looking for different avenues for their portfolios. Half the presentations at the conference were on some type of hedge fund or alternative fund investing. It is my opinion that by the end of this decade so-called alternative investments will be seen as logical investments. I also think they will be available to the public at large.

This week has gone by way too fast. I hope to post another chapter to my book-in-too-slow-progress (called Absolute Returns) on the web next week at www.absolutereturns.net and finish another (free) Accredited Investor E-letter, where I write about private offerings and hedge funds. For more information on the letter, you can go to www.johnmauldin.com and click on the e-letter link.

Have a great week, and take the opportunity this week to call an old friend or family member and tell them how much you love and appreciate them.

Your ready for the weekend analyst,

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