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Fifty is the new Twenty

Although we live in New York, one of the most expensive areas in the country, I think many people in the US can appreciate that for routine purchases of goods and services the $50 bill is beginning to replace the $20 bill as the bill of convenience. Topping up a tank of gas easily runs $50. Park overnight in New York City: $50+. A night at the movies for two with pizza afterwards, you guessed it, $50. Anecdotal evidence everywhere points to rising prices. Official claims to the contrary, inflation seems to be creeping in on little cats' paws.

What is the ideal level of inflation? The Fed says 2%, a rate that doubles prices in about 35 years–no worry. Lower than that raises fears of deflation where falling prices incentivize purchasers to delay purchases today in expectation of lower prices tomorrow. Lower demand at best hamstrings growth and can lead to recession as in 2008-09 or even depression as we experienced in the 1930s.

Recently, according to the Bureau of Labor Statistics, core inflation excluding food and energy costs, has been rising at 2%, just about where the Fed wants it.

There are two opposing camps when it comes to the outlook for future inflation. The bulls (benign inflation ahead) claim that there are structural reasons inflation will remain subdued. An aging population in the US means slowing demand and growth. High unemployment suppresses demand as well. Labor is in a poor position to demand rising wages in this tepid recovery.

The bears (higher inflation ahead) point to the writings of Milton Friedman and the Austrian school of economics claiming that inflation is first and foremost a monetary phenomenon: too much money chasing too few goods which results in upward pressure on prices.

We are inclined to side with the bears. For five years the Fed through open-market purchases of bonds has injected an unprecedented amount of liquidity (read money) into the economy of the US creating artificially low interest rates thereby hoping to stimulate demand and growth. They have literally been printing money out of plain air depreciating the value of the dollar. This is one of the hallmarks of fiat money which is unrestrained by the backing of a scarce commodity such as gold.

We would argue that the reason that prices have not yet skyrocketed in the face of the $3 trillion of purchases of bonds with newly created dollars is that the banks who sell the bonds to the Fed are not lending the money they receive in return. The reasons are complex: regulatory oversight, punitive penalties and vilification have made the banks cautious and gun-shy about lending. Instead of lending, the banks deposit the proceeds of bond sales to the Fed with the Fed itself. As a result, the money that the Fed is supplying is slow to circulate through the system creating only weak demand. Slack demand begets deflationary headwinds in the economy. Hence subdued inflation–for now.

The Fed is in a tough, if not untenable, situation. As the economy eventually approaches full employment of resources despite low growth, prices could begin to increase more sharply as scarcities arise. The Fed can then opt to raise interest rates to try and reign in inflation. This would slow down economic growth and maybe push the economy into recession. Not a happy event. Or, it can tolerate higher prices. But a little inflation, as the old saw has it, is like being a little bit pregnant. It tends to grow. History has all too many examples where the authorities that be have chosen inflation over austerity.

To hedge against inflation, we have recently increased our exposure to gold related investments. We are most assuredly early but intend to add to positions as developments warrant.

Meanwhile, the stock market is lollygagging around new historic highs even as the economy limps along (first quarter GDP was an annualized negative 2.9%) and economists are tempering their expectations for future growth. But there is little enthusiasm evident in the stock market. Individual stocks rise to new highs but are lethargic and lack the conviction to break away strongly. Volume is very low. All this is disconcerting. Is this the pause that refreshes or the calm before the storm? Many of our stocks are fully valued in our opinion and we are tempted to sell. For the time being we are sitting tight. However, we will likely raise cash levels as we edge towards a more defensive posture.


Tom Herzig


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