3/9/2011 3:31 PM ET.
|By Anthony Mirhaydari, MSN Money
5 lies the economists are feeding ushttp://money.msn.com/exchange-traded-fund/5-lies-the-economists-are-feeding-us-mirhaydari.aspx?page=0________________________
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Reassurances from the Fed on down about low inflation and falling unemployment are ringing hollow as stagflation looms. They aren’t fooling us, but they might be kidding themselves.
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.Related topics: Federal Reserve, economy, Ben Bernanke, investing strategy, Anthony Mirhaydari
Economists aren't exactly held in high regard these days.
The run-up to the 2008 financial crisis and the deep recession that followed were accompanied by reassurances from economists all the way up to Federal Reserve chief Ben Bernanke that the subprime mortgage problem was "well contained."
British economists even issued a formal apology to the Queen after she berated them for not predicting the credit crunch. Their rationale? That many were guilty of "wishful thinking combined with hubris."
Now, the same brain trust of mainstream academics and economists is offering reassurances that ring just as hollow to the person on the street. Their main arguments: Rising food and fuel prices aren't a concern and rising "core" inflation isn't a threat.
Economists tell Queen they're sorry
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While they are at it, they also claim that ultraloose monetary policy hasn't fueled commodity and food inflation -- even though we've seen a 38% increase in the DB Commodity Tracking Index and a 22% increase in the U.N. Food Price Index over the last seven months. After all, they say, measured inflation is still very low, manufactured goods are still cheap, and wage pressures are contained because of high unemployment.
All of these theories have been espoused by Bernanke and other members of the Fed's policy committee, and by prominent Wall Street economists and investment strategists. But growing evidence suggests they just aren't true. In fact, they're flat wrong. So believe these five fallacies at your peril:
1: Inflation isn't a threat
Over the last few months, I've repeatedly discussed the rising threat of inflation and the specter of higher interest rates in a series of columns and blog posts. And for good reason: I think these upward trends will be the economic linchpins for 2011. Higher prices sit at the center of all the current major issues: energy, monetary policy and government credit risk.
Anthony Mirhaydari
.These issues will be critical in determining whether a double-dip recession or period of economic stagnation awaits us.
Interest rate hikes to combat inflation are already well under way in the developing world. On March 8, Vietnam raised rates by 1% to 12%. Market chatter has China raising its reserve requirement ratio for the ninth time since 2010 to tighten lending. Thailand and South Korea are expected to raise policy rates this week, following rate hikes by Indonesia in February.
With the economic recovery now in its third calendar year and with crude oil prices up more than 55% from last summer's lows, central banks in the developed world are being forced to take action. Last week, the European Central Bank signaled that it will more than likely raise rates at its April policy meeting -- despite the fragile state of peripheral eurozone countries like Greece and Portugal.
US vs. Europe on inflation
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But if you listened to Bernanke's recent testimony to Congress, and to the comments of some of the more dovish members of the Federal Reserve, you'd think this era of ultracheap money and low inflation will just keep going. For them, there's no problem at all. Bernanke told Congress he believes big increases in the prices of food and fuel will have only a "temporary and modest" impact on consumers.
Make no mistake, inflation is here and central banks will have to react.
2: 'Core' inflation is all that matters
Of course, there is also the question of whether economists are even properly accounting for inflation. Right now, the Fed's preferred measure -- the core personal consumption expenditure price index -- is rising at just a 0.8% annual rate.
You probably feel like inflation is much higher than that piddling number. That's because the core rate excludes rises in food and energy prices. Don't you wish you could just exclude those price hikes from your household budget?
The reasoning behind the exclusion is that these volatile necessities won't keep going up over the long term. Economists assume food and fuel inflation will be "contained" -- just as rising mortgage defaults and foreclosures were "contained" to subprime borrowers back in 2007.
The latest Beige Book report of economic conditions, produced by Fed researchers, suggests otherwise. The report noted that nonwage input costs are increasing and that "(m)anufacturers in a number of districts reported having greater ability to pass through higher input costs to customers. Retailers in some districts mentioned that they had implemented price increases or were anticipating such action in the next few months."
There's more. The ISM manufacturing and nonmanufacturing prices-paid indexes have surged to levels not seen in three years. Crude material prices are up a massive 52% over the past three months, even if you exclude food and fuel. Inflation is spreading and becoming entrenched in the supply chain for all goods, despite assurances to the contrary.
To get a clearer picture of what's really going on, we turn to John Williams of ShadowStats.com. He holds the official data in low regard and earns his living ironing out wrinkles in the government's economic statistics. By reverse-engineering changes to how metrics like unemployment and inflation are calculated, Williams believes, investors can get a truer picture of what's going on. It's not pretty: His inflation measure is riding at a 9.1% annual rate.
3: The Fed isn't making it worse
You will, of course, find a few economists (and a lot of Tea Party types) who say the Fed's near-zero interest rate policy and its $600 billion "QE2" money-printing operation are contributing to higher food and fuel prices, both at home and abroad.
But the big guy, Ben Bernanke, doesn't believe it. Charles Evans, the head of the Chicago Fed, agrees. He told CNBC recently that he doesn't expect higher energy prices to end up in underlying inflation. He added that "accommodative" policies are not the reason for the recent commodity price rise.
To be fair, there are voices of reason within the Fed. Dallas Fed President Richard Fisher, for instance, recently said that he may vote to halt further QE2 action before the June deadline. He believes QE2 may be counterproductive and that more monetary policy accommodation (or more cheap cash) could actually hurt the U.S. economy by inciting more inflation.
.I couldn't agree more. And the bond market seems to be on board, too.
The McClellan Market Report's Tom McClellan, a former Army helicopter pilot and a veteran chart technician, has found that the yield the market gives two-year Treasury Notes tends to do a better job of setting monetary policy than the Fed does.
The two-year yield suggested tighter policy (higher interest rates) in the 1990s during the tech stock bubble. It suggested tighter policy during the housing bubble years. It suggested tighter policy during the 2008 commodity price spike. And it's suggesting tightening policy now.
4: The 'output gap' will keep inflation down
To get a little wonkier, what of the so-called "output gap" in the economy created by higher unemployment and idled factories? Many, including Bernanke, make the argument that you can't have inflation with so many people out of work. Yet that just isn't so.
The idea that unemployment and inflation are linked gave rise to an economic model dubbed the "Philips curve" and was popular in the 1960s and early 1970s. It suggests a direct tradeoff between unemployment and inflation. And it helped lead then-Fed Chairman Arthur Burns astray by providing intellectual cover for him keeping monetary policy too loose during the oil price shocks of the time -- which, like now, were driven by political turmoil in the Middle East -- in an effort to get the unemployment back down to the sub-4% rate that had prevailed in the late 1960s.
The result was a debasement of the dollar, a spike in food and fuel prices and a painful period of stagflation ( inflation accompanied by economic stagnation). Sound familiar?
I fear a similar scenario is playing out now. Bernanke's Fed has been lulled into a false sense of security that "core" inflation will stay low because of still-troublesome unemployment levels. The idea is that wages will stay low, preventing a wage-price inflation spiral in which employees demand cost-of-living raises while employers increase prices charged to consumers to compensate.
Another contributor to that false sense of security has been provided by the disinflationary influence of China's cheap factories and low-wage workers over the last decade. But that's ending now as the Chinese run out of laborers and the costs of shipping and raw materials soar.
Société Générale economist Aneta Markowska (yes, an economist, but a rare out-of-consensus thinker) finds that China's inflation rate historically affects the U.S. inflation rate -- via import prices -- on a 20-month lag. As a result, holding all else equal, we should expect the U.S. core consumer price index to increase from 0.9% to more than 2% over the next year and a half. Add in the domestic impact of higher food, fuel and commodity costs, and it's easy to see core inflation pushing to 3% and beyond.
All the ingredients for stagflation are in place. Just don't expect Bernanke or other dovish members of the Fed and the economic cognoscenti to admit it.
5: Unemployment is below 9% -- and the old jobs are coming back
For most in the United States, the job market likely feels worse than the 8.9% unemployment rate suggests. Maybe the broader "U6" measure at 16.7% feels more accurate, since it includes those who have become too discouraged to seek work, as well as marginally attached workers.
John Williams' measure of unemployment, which removes unstable seasonal factors and other distortions and adds long-term discouraged workers, stands at 22.1%. Further, the work force participation rate has fallen to just 64.2% -- a level not seen since the early 1980s.
Another problem has to do with what kind of jobs the economy is creating. Many of the unemployed, especially those who had held jobs in industries such as manufacturing, continue to hope they can find new jobs that are just like their old ones. In other words, they won't have to retrain and learn new skills. Bernanke, along with members of the San Francisco Fed, says this is still largely the case. If so, the job market could heal quickly.
This approach centers on what's known as the structural unemployment rate. If it's low, as Bernanke believes, the unemployment rate can drop very low without inciting inflation. But if it's high, it means the unemployment rate will fall gradually as workers slowly retrain and move into new industries. Higher inflation will thus result as wages in fast-growing sectors increase to attract new talent.
Unfortunately, a growing body of evidence suggests the structural unemployment rate is on the rise. That means that many of these old occupations -- such as mortgage brokers and real estate agents -- just aren't coming back.
Markowska says the structural unemployment rate could be closer to 7.5%, rather than the Fed's 5% estimate. Why? She notes that despite current levels of joblessness, many workers are enjoying sizable pay increases. "Interestingly, we tried to look at the relationship for individual sectors and found a very loose link between unemployment rates and wage growth. The most shocking was construction, which is posting the fastest wage growth, at 2.6% year-over-year." Wages are also rising fast in the financial, education, health and information sectors.
This suggests that despite an army of unemployed Americans, businesses have to pay more to get highly qualified workers. Comments from the latest Chicago PMI survey (.pdf file) corroborate this: "Hiring is now above pre-layoff levels. Hiring is targeted to Rock Stars who make MUCH MUCH more than previously eliminated managers." Believe it or not, a skill shortage is beginning to develop.
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Translation: Many of the unemployed will be forced to retrain and move into new areas of the workforce. And the Fed has less room to maneuver than it thinks, because unemployment could fall only from 8.9% to 7.5% before inflation ramps up in a big way. Over time, as workers retrain and move into growing industries, the structural unemployment rate will fall. But that takes time.
Moving the goalposts
So Fed policymakers and government bean counters aren't just failing to tell us what's really happening in the economy; worse, they seem to be fooling themselves. If that's not another round of wishful thinking combined with hubris, I don't know what is.
Overall, the situation is desperate enough that over the past few weeks I've recommended a net short positioning to my newsletter subscribers, along with a scattering of select long position in strengthening emerging market equities and exchange-traded funuds. Both the Market Vectors Indonesia Index Fund (IDX) and the iShares MSCI Thailand Investable Market Index Fund (THD) look very attractive. As does the iShares JPMorgan USD Emerging Markets Bond Fund (EMB) for you fixed-income fans. For individual stock picks, I like two Chinese names: Puda Coal (PUDA, news) and Shanda Games (GAME, news).
Stocks are set for a period of poor performance in the months to come as investors begin to peer through the lies and realize that our economic quagmire has no easy solutions. The last secret weapon -- the $600 billion QE2 initiative -- won't work a third time. And that's because we face an inflation threat now. So avoid sensitive, "high-beta" cyclical small-cap materials, semiconductor and technology stocks. If you can handle the risk, look at short ETFs, including ProShares UltraShort Semiconductors (SSG). If you have to have U.S. long exposure, look at defensive sectors such as utilities via Utilities Select Sector SPDR (XLU).
The last time stagflation took hold, in the early 1980s, it took the iron will of Paul Volcker, a double-dip recession and 22% interest rates to slay the beast. Let's hope we don't go back to those dark days.
Be sure to check out Anthony's new investment advisory service, the Edge. A two-week free trial has been extended to MSN Money readers. Click the link above to sign up. Mirhaydari can be contacted at anthony.mirhaydari@live.com
