Dollar Overhang And The Prospects For Inflation
By Robert Milan

“The number one concern of institutional money managers around the world isn’t Iraq, or a double dip, or accounting. The number one concern is deflation. How do I know this? In recent days, I’ve had numerous telephone conference calls with investors in London, Paris, Geneva, Zurich and Madrid. I’ve met with several equity portfolio managers in New York, Chicago and St. Louis. In every town, we spent much of the time discussing the likelihood and consequences of deflation. Everyone seemed to agree that deflation is a clear and present danger, and that it can’t be good for earnings.” - Dr. Edward Yardeni, Chief Strategist, Prudential Financial

We can not argue with Dr. Yardeni’s view of what the consensus opinion is with regard to the prospects of inflation and deflation. However, we adamantly disagree with this consensus view. In our view the prospects for a new and serious round of inflation are very real and could be very near.

Our case for an imminent bout of inflation begins with the very simple fact that the Federal Reserve continues to increase the money supply at extremely rapid rates. Taking the long view, the money supply, as measured by M2, has climbed from 1,754 billion dollars at the start of 1982 to 5,700 billion dollars by September of this year. This is a more than tripling in the money supply during this 20 year period. Yet during this period the loss in the purchasing power of the dollar has been relatively restrained. According to the United States Department of Labor’s Bureau of Labor Statistics, it would require only 182 of today’s dollars to equal the purchasing power of 100 dollars from 1980. A one to one match up between the increase in dollars and a decline in purchasing power, of course, would mean that somewhere near 324 of today’s dollars would be required to equal 100 dollars of 1980 buying power.

Now, we are not blind mathematical monetarists who believe there is some magical formula that will always explain the exact relationship between increases in money supply and prices. However, we believe it is important to understand just why prices have not climbed more dramatically during this two past decade period. And, upon examination, we believe there are three factors that have dampened the inflationary environment up to now, and it is changes in these three factors which make inflation such a major threat in the near future.

The first factor is inflation sentiment. Often fears of inflation can take a long time to brew. Through out the 1960's, a period when M2 money supply doubled, inflation crept up slowly. The GDP implicit price deflator started the decade at around 1.4% and finished the decade at 5.2% on a year-over-year basis.
The 1970's were a different story. For the entire decade M2 money supply climbed by a multiple of 2.5. But, the inflation picture was dramatically different.
From 1970 to the end of 1972, inflation generally remained between 4% and 5%. In 1973 it climbed to 6%. But all hell broke loose in 1974, when inflation climbed at a 10.4% annualized rate. For the remainder of the decade it never dropped below 5%, despite periods of severe recession. The early 1980's were much of the same. Inflation in 1980 hovered at 9.7%. The first quarter of 1981 again saw an inflation rate of 10.4% It was during this period that gold displayed its dramatic rise. From a 1979 low of $216 per ounce, it climbed to its peak of $850 an ounce in early 1980.

Clearly, while inflation fears were relatively docile in the 1960's, they were very near out of control by early 1980. It was this fear, of what at that time was called galloping inflation, that caused the severe run up in the gold price, which certainly acted as an indicator of the inflation sentiment. It was inflation sentiment, though, that had clearly gotten ahead of itself.

The money in circulation wasn’t enough to justify these dramatic price climbs. And by the late 1980's money supply growth under the watchful eye of Federal Reserve Chairman, Paul Volcker, slowed significantly. The slowing in money growth killed any inflation fears that might have remained in the populous. This was the first nail in the coffin of any inflation in the then near future. By the end of the 1980's, the populous, perhaps not fearing deflation, certainly had little fear of the type of galloping inflation that began the decade.

The second factor which has put a damper on inflation is the current remarkable growth in productivity. The home PC, the internet and the overall explosion in new technology has resulted in the production of better quality goods, faster production of them and more of them. This explosion in productivity has been like a blanket smothering out potential inflationary effects of money growth, particularly the money growth in the 90's.

The third factor dampening inflation was the absorption of dollars in Europe. The recent introduction of the euro in Europe proved very beneficial in easing potential inflation here in the United States. Many of the dollars created by the Federal Reserve simply ended up in Europe. The dollars originally went to Europe, to a significant degree, because of the introduction of the euro. Over 16% of European business is conducted in cash on the black market. With the local currencies about to be converted to the euro, black market merchants in Europe feared that their homeland currencies such as the French franc and the German mark would become totally worthless at the time of forced conversion. Since these black marketeers couldn’t convert their homeland currencies at their local banks—too many questions to answer, too many forms to fill out. The black marketeers, for the last couple of years, began dealing with the dollar. It is estimated some 30% of all United States physical currency is overseas.

But now that the conversion has occurred, the euro offers a sensible alternative to the dollar for Europeans and other foreigners, including merchants dealing on the black market but certainly not limited to black market merchants.

The start of the conversion in Europe to the euro, at the physical currency level, began in January of [2002] and for most countries was completed by the end of March. Not coincidentally you had strength in gold and weakness in the dollar at the beginning of the year and again at the end of March. While Europeans haven’t as of yet started sending dollars back into the United States, the completion of the conversion over to the euro has resulted in the end of this European demand for new dollars. The dollars remaining in Europe because of the euro conversion remain part of the great “Dollar Overhang,” which could comeback to hit our shores at anytime. An overhang that also includes net external United States debt of $2.7 trillion owned by foreigners.

These are the three factors that we believe have kept a damper on domestic United States inflation. To varying degrees, the protection, each three have afforded against inflation in the past, no longer exist.

Let us now exam how the influence of these factors has changed.

First. The productivity factor. Productivity gains occur only because of capital and labor directed toward increasing production. Since 9-11, growth in government and government spending has mushroomed. According to a Heritage Fund estimate, the federal government will spend nearly $800 billion more in the four-year period 2000-2003 than it did during the previous four-year period. That’s approximately an additional $5,000 per household. And, that’s $ 800 billion that can not be directed toward capital investment. And that doesn’t take into account the number of laborers that are no longer working in the private sector as producers but that now work as a part of private or government stepped up security since 9-11. The exact decline in productivity as a result of these changes is difficult to quantify, at this early stage of the process. However, it is our belief that most prognosticators are underestimating the decline in productivity ahead, if they are taking it into consideration at all.

Second. Inflation sentiment is clearly biased towards deflation at present, as evidenced by the quote from Dr. Yardeni above. This is the factor that up to this point has changed the least. But our belief is that the fears of climbing inflation, once stoked, will not result in years of incubation that, say, took place in the 1960's . Too many people have very clear memories of the late 1970's- early 1980's. That period, in a sense, was an education period for individuals. It taught them what to do and what to buy when inflation strikes. What took them years to learn back then, they will be able to put into practice in just weeks this time around, once they believe inflation is a threat again.(We believe, for example, it is possible for gold to spike from its current level to $1000 per ounce in just weeks, once inflation fears take hold.)

Finally, the “Dollar Overhang.” We view this as the ticking time bomb. The conversion of the euro is now complete, so this entire reason for holding dollars has been eliminated. But further, foreign investors now have a legitimate alternative to the dollar in the euro as a place to park funds. This can only be bad news for the dollar. Once the momentum in a huge market such as the dollar begins to turn, and it is starting to turn (The dollar has lost some 15% of its value YTD against the euro.) it is difficult to stop and tends to take on a life of its own. It is thus this dollar overhang which is the factor which can create the most immediate and long-term damage.

Coupled with these factors is a Federal Reserve policy that continues to be accommodative. M2 money supply has increased a near 20% over the last two years.

In summary, a Federal Reserve stance toward monetary growth no longer faces the luxury of having any hardcore reason as to why it should be absorbed overseas. Further, expected declines in productivity, point to a major undoing of this factor in the cushioning of United States domestic inflation.
Finally a comment must be made about our view of inflationary prospects and the view of the consensus. it is quite remarkable to see our opinion so diametrically opposed to that of the consensus. It is truly a critical dissent. Clearly, dramatically different business, investment and trading strategies should be maintained depending upon which scenario proves out.

What is the cause of the diametrically opposed views? We believe it ultimately comes down to the fundamentals of the methodology of economics as a science. We believe the consensus opinion is largely spawned by mathematical model building that tends to forecast a future which is not much different the present. These forecasting strategies work for as long as trends don’t change significantly. But the trend following methodology will always miss the big changes. We, on the other hand, think of ourselves as deep thinkers who try and get to the root of things and we think we have our hands pretty well wrapped around the roots of the current situation. If we are correct, it is best you start thinking now about how to survive and prosper in an inflationary environment.
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