"Kee" Points with Jim Kee, Ph.D.

I thought it might be a good idea this week to step back from the data minutiae and talk about a few important conceptual issues for understanding the current global investment landscape.

 

There is no inflation in the developed world, and only a handful of developing economies are dealing with real, i.e. double-digit, inflation (they are Russia, Venezuela, Egypt, and Brazil). Most people confuse inflation – a general decline in the purchasing power of a currency - with relative price movements. For example, a rise in the price of oil or a rise in wages isn’t inflation. Rather, it is a relative price movement; that is, it is a change in the price of one good relative to another. Relative price movements aren’t inflation and can’t cause inflation. For example, if people spend more money on oil, bidding up its price, that leaves less money to spend on other things, putting downward pressure on their prices. Those are relative price movements. Inflation, on the other hand, means that the prices of everything are rising, and that can only really happen if the value of money is declining, usually because too much of it has been issued. To believe otherwise is to commit what economists call the “fallacy of composition,” or believing that what’s true for the part is true for the whole. In fact, the notion that an increase in prices in one area, like oil or wages, can “push” up all other prices, leading to inflation, is often called the “cost-push-theory” of inflation, but it is really the cost-push fallacy. The fact that even professional economists sometimes slip into cost-push theory led economic historian Thomas M. Humphrey (Federal Reserve Bank of Richmond) to write a paper on the subject, titled “Historical Origins of the Cost-Push Fallacy.” I’ve always found Humphrey’s conclusion fascinating and worth sharing:

 

“The longevity of cost-push theory challenges the very notion of economics as a progressive science. Any scientific discipline addressed to popular and professional audiences alike should be able to rid itself of discredited ideas once and for all. In the case of cost-push, however, economics has been unable to do so. For at least 200 years, critics have repeatedly exposed the fallacies of the theory. Yet each time it has bounced back with its popularity intact.”

 

It is also common today to hear the cost-push fallacy used to describe the impact of lower import prices on producing deflation. But here again that is a relative price movement, in this case the price of imports relative to other goods and services. Relative price movements can often move price indexes around, particularly if they are a big part of the index. But that’s not inflation or deflation, just the impact of relative price movements on the index. Price indexes just measure the cost of buying a specified basket of goods and services from one time period to the next. If the basket is chosen poorly, then the index will be overly influenced by relative price movements and it will be a poor measure of actual inflation. In fact economists have attributed these sorts of relative price distortions to account for 1% to 2% of measured inflation. That’s why 2% is so widely used as an inflation target. If measured inflation is 2% (i.e. as measured by an index), then actual inflation is probably close to zero.

 

Is inflation really that simple? Not quite. The above assumes that people desire to hold a constant amount of money (that’s called money demand), spending the rest. But if peoples’ desired money holdings increase, then their spending decreases, putting downward pressure on prices. Sometimes people desire to hold more money in times of uncertainty, which is called precautionary demand. Economists call this a decline in money velocity, or the pace at which money is spent. Just as you would expect, money velocity has fallen dramatically since the Great Recession as people have chosen to hold more money for precautionary reasons. That’s also true around the world, where precautionary demand is being fulfilled with fixed income instruments like bonds, particularly US bonds, driving up their prices and lowering their yields. As an aside, in order to buy US bonds you have to have US dollars, and foreign buyers sell their own currencies to get those dollars. That leads to an increase in the value of the dollar globally and a decrease in the value of other currencies used to buy dollars. The strong demand for safe havenassets like bonds was true in much of the developing world even before the Great Depression, as the collapse in Asian economies in the late 1990s created a hesitancy to reinvest in those economies, even after they recovered. That money too ended up in fixed-income instruments, leading to what Ben Bernanke described as the global liquidity glut. All of this goes a long way towards explaining why you see low inflation and a strong dollar – it can’t all be attributed to “currency wars.”

 

But that’s also a possible source for optimism, at least at some point in the future. You have on the one hand a tremendous amount of global capital tied up in safe-haven fixed income instruments. And on the other hand you have the majority of the world’s population still in need of massive infrastructure spending as they go from rural to urban; from primitive to modern. In the developed world you see rapid technological obsolescence, as information technology marches on while corporate and consumer spending on technology lags. At some point all of this capital will address all of these needs, and then you’ve got a pretty good story from an investment perspective.

 

Any other sources of optimism? Yes. According to a recent study by the Federal Reserve Bank of San Francisco, one of the reasons that the steep decline in oil prices has not led to a strong boost in consumer spending is that consumers expected this oil price decline to be temporary. So “households saved rather than spent the gains from lower prices at the pump” (Federal Reserve Bank of San Francisco). The authors conclude “continued low oil prices could change consumer perceptions, leading them to increase spending.” Their results seem both fairly obvious and yet widely overlooked. True, at the national level, some of the savings from lower energy prices have been offset by increases in health care costs. But certainly a lot of the unspent gains both in the US and across the developed world has to do with the fact that only recently has the perception of “lower for longer” taken hold. That’s the case for increased global gains from lower energy prices going forward. If perceptions change, people should start spending more.