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
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
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
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.
Please read our important notice
about these letters and the securities they mention.