Down with Inflation

by Bruce Fenton

Despite a consensus opinion among market followers that we are in for another round of Federal Reserve interest-rate hikes, the current year’s outlook, and continuing for the next several years, is “all systems go.”

Driving this are the economic forces of continued growth of the U.S. economy at a sustained and healthy pace, coupled with strong global deflationary forces that will act to keep wholesale and retail prices down, thus curbing inflation and the Fed’s need to make dramatic rate increases.

The importance of inflation to stock market investors cannot be overstated. Profits, interest rates, and inflation are the fundamental variables in the pricing of stocks. If profits continue to grow, the future value of a business (as represented by stock ownership) grows. Therefore, investors should be willing to pay more for the stock.

But the future value of those business earnings must be related back to a present price. If inflation in the future robs the purchasing power of earnings, or profits, the stock is less valuable today. Conversely, if inflation falls and the earnings of the business buy more, the stock has a greater value today. If there is no inflation, the stock price should stay the same.

Understanding this principle, it is easy to see why some traditional investors who looked only at today’s lofty price-earnings ratios could conclude that stocks are overpriced. However, if they had factored in lower inflation, they might have been more willing to pay today’s stock prices.

The Federal Reserve’s role is to attempt to control inflation by controlling short-term interest rates. If the Reserve can cool an overheated economy by raising short-term rates, the long-term outlook for inflation (as measured by market expectations priced into falling long-term bond yields) becomes positive for the markets.

The Fed doesn’t have to shoulder the entire burden of controlling inflation. A number of other factors impact price direction. First, there is growing foreign competition, spurred on by a decade of world capitalism. This competition makes it difficult for businesses to raise prices.

Second, domestic competition has intensified as buyers have more power, thanks to the Internet, to shop for lowest prices. Lehman Brothers economist Stephen Slifer calls the impact of the Internet on pricing “the most deflationary event of our lifetime.”

With foreign competition breathing down their necks, and consumers everywhere able to shop for the lowest prices, how can the great companies of our country survive and continue to employ our workers and produce profits? In a word: “Technology.”

By becoming more efficient and growing their markets, businesses can compete in a falling price environment. Technology has increased productivity and made this possible. Businesses can exercise the same competitive strength as buyers, which their own customers use against them. For example, by using the Internet to shop for lowest-price supplies, businesses can achieve cost savings.

The need to be more efficient and competitive will give rise to an evolution of larger businesses. Small businesses will become incubators for technology and new solutions, but many will lack the resources to compete on a global scale. Their ideas and solutions will be consolidated into larger companies with the resources to compete.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Inflation Headlines

by Bruce Fenton

That nasty “I” word…inflation is making headlines again and helping to kick stock prices around like a ping-pong ball. Just about the time we have grown accustomed to what economists like to call “benign” inflation, prices are inching up.

The classic definition of inflation is a persistent increase in the price of goods and services in the economy as the purchasing power of money decreases. The opposite of inflation, or deflation, is an economy where prices are falling and the purchasing power of money is increasing.

Putting this in perspective, there is a web site run by the University of Miami and Wake Forest University where you could enter a value in any year going back to 1665, and relate the purchasing power of a dollar up to year 2003. Checking a few years at random, you would find that in the year 1700 today’s dollar would buy $23.66 of goods. In 1865 the figure was $11.23. In 1900 a dollar today would buy $21.79, and by 1980 a dollar would buy $2.23 in goods and services.

Inflation has been a constant in our economic history, and except for periods of war and the 1972–1982 years, stayed under 5%. Long, continuous periods of deflation have also been a part of the picture. Historically our long-term deflation was the end result of increased efficiency as we opened the west and made incredible technological advances in the 20th century.

In today’s dollars, 1981 oil is worth about $92 a barrel…that’s about 50% higher than we are actually paying, and we are using less!

While I realize this is not on your mind when you are pumping $50 worth of gas in the family SUV, keep in mind that our household income has gone up more rapidly than inflation, giving us greater purchasing power today than we had in 1981.

Many of the current financial press discussions of inflation center on the impact of rising energy prices and the projected tightening of the job market in 2006 and beyond.

Another view on inflation has been expressed by best-selling author, Harry Dent, in his book “The Great Boom Ahead,” and his latest, “The Next Great Bubble Boom,” Dent makes a case for inflationary pressures resulting from younger workers moving into the work force. Younger workers cost more to train, are less productive, and more costly to employ. Since they make less and want more, they borrow to finance their entry into adulthood. The net result is higher prices, higher demands for money (increase in interest rates) and higher inflation.

If Dent is correct, since there are fewer young people coming into the work force, this blip up in inflationary pressures will be short-lived and not change the secular trend of inflation, which has been sloping down since 1982.

Bruce Fenton is a financial consultant, a writer, and the president and founder of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.

Inflation Economics

by Bruce Fenton

As the economy continues to show signs of improvement, members of the financial press who believe that bad news sells better than good news are sniffing around looking for signs of inflation. The only ones who cheer inflation are those who have borrowed long-term and will have the chance to repay in cheaper dollars. The rest of us could do without the beast.

Inflation is an insidious tax on future value for most consumers and investors. Our money doesn’t buy as much, the interest we earn on CDs and other fixed income securities is worth a bit less, and retirement on a fixed income is downright frightening.

The common perception of inflation is that it is caused by too many dollars chasing too few goods, forcing prices up. Basic economics classes teach that wages spiral up, putting further pressure on prices as inflation continued unabated.

We learned in the 1970s that inflation could be stimulated by sudden price increases in commodities such as oil and gas. We have also been barraged with the idea that our government can print money by spending more than it takes in from tax revenues.

Government spending during the Reagan years created huge deficits, but strangely enough, inflation fell and has continued to fall from its peak in the early 1980s.

Now, the press, looking for bad news to write about, is focusing on accelerating commodity prices, the falling dollar, rising shipping costs and economic growth that exceeds its monetary potential—all forces that could cause prices to rise and bring a return of inflation.

During a period of downturn, we normally see disinflation (falling prices) result from declining consumer spending and subsequent lack of business investment. Producers lose pricing power. There remains a low level of resource utilization as businesses have excess capacity and unemployment exists.

As the business cycle turns to the upside, inflation rates fall, as they have in five of the last six cycles during the first three years of the recovery. This decline is largely due to increased productivity as businesses become more efficient and do more with less.

This decline and recovery has been different than most—consumers have continued to spend money, and the main downturn in spending has been focused on the investment side as firms needed to work off excess capacity built up during the tech boom of the 1990s.

The growth in productivity we are witnessing is astounding many economists. Recent figures on productivity growth show the highest gains in productivity since the end of the recession in 1961. The impact on prices has been positive as businesses have been able to produce more for less and have not had to raise prices.

Inflation hawks still want to hang their hats on the “falling dollar” tree, citing the higher prices we will have to pay for imported goods.

Logic certainly tells us productivity cannot continue going up forever, and we will not be able to ignore a long-term impact caused by the falling dollar. But for now, inflation is not a factor, and, barring outside events such as a mid-east shutdown of oil flow, inflation should not be a hindrance to our economic recovery.

For an early warning of impending inflation, watch the long-term bond market. Falling bond prices coupled with rising yields remains a good bellwether for inflation.

Bruce Fenton is a financial consultant, a writer, and the Managing Director of Atlantic Financial Inc. Bruce welcomes inquiries, comments, and questions. He can be reached by contacting The Fenton Report.