Import prices are only one component of inflation, and oil prices are only one component of import prices. While oil prices surged in May, other commodity prices fell back somewhat with gold, traditionally an inflationary bellwether, retreating significantly below the $400 per ounce level. Nevertheless, the other factors affecting inflation: wage costs (including in particular the cost of health care benefits), real estate costs and capacity utilization, are all trending upwards.
It thus raises questions in the mind of the suspicious that the release of the producer price index (PPI), traditionally one of the two mainstream measures of inflation (the other being the consumer price index) was delayed Thursday, owing to technical difficulties. This is the second delay this year. The Bureau of Labor Statistics, publisher of the PPI, have had considerable difficulties, with their multifactor productivity statistics (key to assessing the reality of the current recovery) having been delayed several months beyond their normal April publication date and, we are told, likely to be only roughly comparable to past years' figures when they are published. "Technical difficulties" therefore could conceivably cover a multitude of last minute minor adjustments in the PPI, the effect of which would be to suppress a sudden surge in the index.
The political imperative behind statistical suppression of a surge in inflation could hardly be stronger. The Cleveland Fed.'s median consumer price index, which looks at the weighted median consumer price movement of all items, rose at an annual rate of 4.1 percent in April, significantly higher than the consumer price index itself, and a substantial increase over the annual rate of 2.4 percent seen in the preceding year. The markets don't closely follow the Cleveland Fed. index, and that is in any case the figure for a single month, which may be distorted. However, if the bond market gets the idea that inflation is running at the 4 percent level, we are in for a very rough ride indeed.
Four percent may be a low estimate of where inflation ends up. M3 money supply, the best predictor of inflation, rose by 94 percent over the 7 year period from 1966 to 1973, an annual rate of 9.9 percent, or 5.1 percent net of the average 4.6 percent per annum consumer price inflation in those years. The result was high inflation in the late 1970s -- averaging 9.4 percent per annum in the eight years 1973-81 -- together with a collapse to almost zero of the historically healthy productivity growth that had been seen in 1947-73.
In the eight years to May 2004, M3 money supply has grown by 93 percent, an annual rate of 8.5 percent per annum, or 6.1 percent per annum net of the average 2.3 percent per annum inflation rate during the period. In other words, a significantly faster real growth rate in money supply than in 1966-73. The result must inevitably also be high inflation, at a rate comparable to the mid 1970s, in the years to come. There will probably also be an equally sharp decline in productivity in the economy, as resource allocation suffers from much of the inefficiency that plagued the middle 1970s.
This is not a result of choosing funny statistics, or funny end dates for the periods observed. The comparison works equally well for M2, up 8.5 percent per annum in the earlier period, and 7.7 percent per annum in the later (i.e. again significantly faster growth in real terms in 1996-2004.) The May 1996 period is of course chosen as the point that best represents the beginning of the recent acceleration in money supply growth, but the December 1966 and December 1973 dates are equally chosen to demonstrate the fastest possible medium term money supply growth in that period; the distortions if any should thus be about equal.
There's no question -- mea culpa, mea maxima culpa -- that I missed the revival in the economy and stock market that we have seen in 2003-04. It's my own fault, for not following sufficiently closely the teachings on money supply of Milton Friedman. If you have rapid money supply growth, then even if the stock market may be overvalued, there is a good chance for a period of rapid economic growth.
But optimists should pause for a moment and ponder the pattern of 1966-1973. In 1968, the stock market was clearly overvalued, with a high level of speculation. It then dropped sharply, while the economy underwent a mild recession and the Federal budget swung from a tiny surplus in 1968-69 to a then record deficit in 1971-72.
At the stock market bottom of 1970, the valuation excesses of the late 1960s had not been wrung out. In real terms, the final stock market bottom in 1982 was 75 percent below the 1966 peak, and 60 percent below the apparent stock market trough in 1970.
After the mild recession of 1970-71, there was a strong recovery, but price inflation, suppressed by controls in 1971-72, burst out in 1973. The U.S. economy went into a much deeper recession in 1973-75, followed by a surge in inflation, while the stock market, which had made a sturdy recovery in 1970-72 sank far below its initial trough in real terms. In other words, as Milton Friedman predicted and Fed Chairman Arthur Burns did not, a period of rapid money supply growth during and after a stock market bubble at first produced an apparently vigorous recovery, but then led to a decade of stagnation, accompanied by much higher inflation and high nominal interest rates.
If you superimpose this pattern on 1996-2004, we now appear to be in early 1973, the point at which price rises began to take off and the economy began to head south.
Not good news for President George W. Bush. Conventional wisdom for the last couple of months has been that his re-election chances will be hurt by the Iraq conflict, but helped by the economy. Like most conventional wisdom, this may prove the reverse of the truth. The formation of the new government in Iraq may swing the Iraqi population behind the restructuring process there, while high oil prices cannot fail to produce a modest measure of Iraqi economic recovery. Consequently by November it appears possible that Iraq will be seen by the U.S. electorate as a difficult and traumatic enterprise, but on balance a success.
The economy, on the other hand, may by November be seriously jeopardizing Bush's re-election prospects. While economic growth, on published statistics (which of course lag) may still be satisfactory, inflation is likely to continue trending upwards, running perhaps by November at around 6 percent per annum on a month to month basis, with the 12 month trailing rate being around 3.5 to 4 percent per annum.
That in turn will spook the bond markets, whatever the Federal Reserve does. If consumer price inflation is even 4 percent and rising, then long term bonds will rapidly come to yield 6.5 to 7 percent, and home mortgages will come to cost 7.5 to 8 percent. If the Fed keeps short term interest rates in the 1 to 2 percent range, as is likely, it will by then clearly be running a policy of negative real interest rates, both unsustainable and highly inflationary. The stock market and the housing market will take account of this, reacting to the higher level of long term interest rates, and will probably be approaching free-fall.
Economic storm clouds, in other words, will by November 2004 be all too readily apparent, perhaps leading to a victory of Democrat candidate John Kerry.
Of course, given the economic prognostication for 2005-2008, it's not clear why he'd want the job!
(The Bear's Lair is a weekly column that is intended to appear each Monday, an appropriately gloomy day of the week. Its rationale is that, in the long '90s boom, the proportion of "sell" recommendations put out by Wall Street houses declined from 9 percent of all research reports to 1 percent and has only modestly rebounded since. Accordingly, investors have an excess of positive information and very little negative information. The column thus takes the ursine view of life and the market, in the hope that it may be usefully different from what investors see elsewhere.)
Martin Hutchinson is the author of "Great Conservatives" (Academica Press, June 2004) -- details can be found on the Web site greatconservatives.com.