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 September 2009 Who are You Going to Believe? Inflation's Relations
With inflation currently at relatively low levels, one might think any concern is misplaced. After all, the economy is still staggering along, needing any help it can get. The country's leaders are spending money as fast as they possibly can without a care about inflation. Even the Federal Reserve, those crusty old economists, aren't worried. According to the minutes from their August 11-12 meeting, "Most participants anticipated that substantial slack in resource utilization would lead to subdued and potentially declining wage and price inflation over the next few years; a few saw a risk of substantial disinflation." Nevertheless, it's hard to shake the feeling they're channeling for Groucho Marx, asking "So who are you going to believe, me or your own two eyes?" If, like most quantitatively-oriented investors, you believe the future is informed by the past, then you should be curious (if not worried) about the coming effects of today's inflationary monetary and fiscal policies. The past forty years have plenty of examples of the damages of well intentioned economics gone bad.
The Basic Concepts The "dollars" side of the equation is controlled by monetary and fiscal policy. The Fed is the nation's steward of the money supply. They indirectly control it by setting short-term interest rates or changing the amount banks have to set aside on reserve. They can directly impact it by buying or selling fixed income securities in the open market. Congress controls fiscal policy which includes financing (taxing and borrowing) and spending. Depending on the amount the government needs for these activities, dollars will either be added or removed from the overall economy. Unlike individuals, the government has the ability to actually print money. To put it simply, when more dollars are needed to finance government spending, it can just print more. That's basically what happened with the last major bout of inflation in the 1970s and 1980s which actually had its roots in the ramp-up of military spending for the Vietnam War in the late 1960s. Arguably, it's what's going on now with budget-busting stimulus spending and financial institution support. It's not difficult to see why this is a problem: If the total amount of goods and services in the economy is relatively fixed in the short-term and the available dollars suddenly rises, prices will, too. If they didn't, the value of goods and services would actually fall in real terms. With more dollars available, each is worth less. It's that old economic concept of supply and demand. A nation's currency is no different than any other economic commodity: The more that's available (supply), the lower the demand -- and value. Although the economy may be able to increase its production of goods and services over the longer-term, inflation can also become entrenched and still impact economic activity. That's why at that August meeting of the Fed, the otherwise sanguine, "Participants noted concerns among some analysts and business contacts that the sizable expansion of the Federal Reserve's balance sheet and large continuing federal budget deficits ultimately could lead to higher inflation if policies were not adjusted in a timely manner." Indeed.
Reason for Concern Now here's where it gets interesting: The Treasury Department is responsible for meeting the financing needs of the federal government. They do this by selling government securities. In order to finance the skyrocketing deficits, they've had to sharply increase the amount of debt being sold. When the Fed buys government securities in the open market, it's essentially buying the debt being sold by the Treasury in exchange for new dollars. The Fed ends up holding the government debt and billions of dollars are injected into the money supply.
As a final consequence, the effective short term interest rate isn't really 0-1/4 percent, it's actually lower -- it's negative. If the nation was locked in the depths of the Great Depression, this would be understandable, but our leaders are convinced things are picking up. If that proves to be true, is there any way this isn't inflationary?
What the Numbers Show This might be true over very short periods of time, but it won't take long for investors to begin to separate real value from nominal value. Most equity pricing models such as the well-known Dividend Discount Model, are based on discounting future cash flows to determine today's fair value. If an inflationary environment is anticipated, those future cash flows will be worth considerably less, presumably reducing today's stock values. But don't believe us, believe your own two eyes. Chart 1 shows the annual inflation and S&P 500 price returns. The patterns are fairly obvious back in the 1960s and 1970s where stock returns fall as inflation rises and vice-versa. In the 1980s inflation is relatively steady, and so are returns. The 1990s have higher share prices as inflation declined until the bear market arising from tech stocks' collapse at the beginning of this decade.
It's difficult, if not impossible, to find any period where inflation was actually good for stock performance. In fact, there's only an extremely slight, negative correlation (-.0988) over the past forty years and even less (-.0014) going back to 1926. These values actually mean there is no statistically significant correlation between them. In other words, changes in inflation have virtually no effect on share prices. (Correlation measures the relationship between changes in two series of numbers. The values can range from +1 meaning there is perfect correlation between them and -1 meaning they always move roughly the same amount but in opposite directions. The closer the correlation to 0 (as in the case of inflation and the S&P 500), the weaker the relation.) There's a little more evidence that when more dollars are chasing those same goods, stocks benefit. Again going back to 1926, there's a weak positive relation between the money supply and the S&P 500 (+.2563). (Here money supply is measured by M2 which consists of currency, checkable deposits, retail time deposits, savings deposits, and money markets.) Even so, the relation between the two has declined more recently, falling to +.1334 over the past forty years.
Investors may be heartened by these results. While they don't show that inflation helps stocks in any way, they don't indicate it harms them either. The virtual lack of correlation indicates there is no real relation. But there's one other thing to consider: Stocks don't trade in a vacuum. While day traders or those who are more technically oriented simply see them as short-term bets buffeted by the daily swings in market sentiment, real investors -- those who look to stocks for long-term returns -- realize there is a company behind their holdings. The reason they look at the fundamentals or use a discount model is because they believe earnings (or something about the underlying corporation's business) drive the stock's price. In other words, they believe there is a relation between a company's performance and its stock price. They think it's a positive correlation. If they're right, then in the aggregate, there should be such a relation between the country's GDP (the sum of all goods and services) and stock prices. And indeed there is. You can get a sense of it on Chart 3. The 1960s and late-1970s appear to show a negative relation with GDP declining as inflation rises, but it's not so clear over the rest of the period. As this suggests, there is yet anothernegative correlation here (-.2714). Unlike the other correlations, this one is apparently getting stronger, rising from -.0865 for the period extending back to 1926. Admittedly, these results are somewhat unexpected. Pundits blamed the high inflation of the 1970s for the decade's dismal markets. The Fed has traditionally guarded against inflation as the arch nemesis of economic growth. The Monetarists of the 1980s and 1990s taught that a rising money supply only increased prices, not actual economic growth. So who are you going to believe, them or your own two eyes? We'd go with your own two eyes. That's not to say there's no need to worry about inflation even if it doesn't directly impact share prices. The corrosive effect of ingrained inflationary expectations has a much more far-reaching effect. Anyone who lived through the 1970s can attest to that. Once the inflationary spiral takes root, it's hard to break. The last time it did in the 1980s, it took some strong monetary medicine to break its hold. Short-term interest rates approaching 20 percent and home mortgages not too far behind are not something anyone wants to revisit. So the good news is, you don't necessarily need to stick all your assets in the mattress should inflation show up. The bad news is, inflation will soon be showing up. Search this site! Just enter you key word or words:
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NFLATION'S ON THE WAY. How could it not be? The U.S. deficit exploded this past year to its highest level ever. It will continue to grow for the foreseeable future. If current proposals for healthcare reform make it through Congress, it will only get worse. If that's not enough, the Federal Reserve and the Treasury Department are collaborating to print money. All of these actions lead to inflation, so should investors be concerned?
