There’s a lot of speculation on Fed moves. Some think the Fed will raise interest rates soon, that inflation is just around the corner. Others fear the economy still isn’t strong enough for tighter monetary policy. With inflation still weak, why not wait before raising rates? For investors, this could have major implications on stock prices. Is a rate increase later this year…
- Just right and will keep us at 2% inflation?
- Too little too late and will stoke higher inflation in a precursor to a 1970’s-like debasement of the dollar?
- Too much too soon and will send us back to deflation?
Let’s play out each scenario. In scenario 1) we’ll be fine. Markets will stay elevated, maybe correcting a little downward to compensate for higher bond returns. But it will be hard for investors to sell with a prolonged economic boom taking shape. In scenario 2) markets may fall, but they will also (strangely) be the only safe haven outside gold to offer protection from raging inflation. Cash flows will follow nominal GDP growth. In scenario 3) markets will definitely fall, but rise again when the Fed is forced to ease quickly (maybe even doing QE4). It may be a long slog before they reach their current levels.
To understand which scenario is most likely, we need a working model of what is happening now. In a previous post, I talked about my balloon-animal theory of inflation, that the fed must tolerate higher asset prices to achieve higher wages. My hypothesis is that because of all the excess labor joining the world economy (China & India), whenever the Fed tries to create 2% inflation to keep our credit economy afloat, inflation turns up in asset prices rather than wages. So the Fed eases to make wages go up, but instead sees internet stocks or houses or the whole S&P 500 inflate instead. Wages stay low, inequality goes up.
To explain why this happens, let’s build a very simple model of the economy. Let’s say there’s 10 people in our whole economy who all work, and a factory in which they work that produces everything they need (100 units). Five of our 10 people own 20% of the factory each. Each share of 20% equates to 2 units in dividends. Our fake world has…
- population = 10
- GDP = 100 units
- Dividends = 10 units
- Wages = 90 units
- Per capita income (total) = 10 units
- Per capita income (laborers) = 9 units (5 people)
- Per capita income (owner-laborers) = 11 units (5 people)
Let’s say 5 Chinese and 5 Indians show up to work in our factory. But they’re new to our society, so they don’t get ownership shares. But trade benefits everyone, so our total income increases to 210.
- population = 20
- GDP = 210 units
- Dividends = 21 units (10% of overall)
- Wages = 189 units
- Per capita income = 10.5 units
- Per capita income (laborers) = 9.45 units (15 people)
- Per capita income (owner-laborers) = 13.65 units (5 people)
What happened? Our economy is better off, and our average income is higher. But the distribution of that income moved away from labor and towards capital. Our owner shares were worth 10 units per year, but are now worth 21 units per year. By bringing more labor into our economy we’ve made the pie bigger, we’ve even made the average pie bigger, but we’re giving a larger share of it to owners.
This is exactly what’s happening today. Trade (and technology for that matter) is amazing in that it allows us to benefit from cheaper goods and services. It also allows poor workers better opportunities to increase their wages. But if you’re in a rich country competing with those poor workers, you’re worse off.
What is the desired central bank response?
The units above are “real” units, not “nominal”. That means a central bank with a paper currency regime could print enough money to keep wages stable. In a credit economy likes ours, that’s exactly what it should do. Otherwise the wage-earners (most of the economy) will be unable to pay their debts because they took out those debts expecting 2% inflation. But their wages have gone down, so those debts can’t be paid. Therefore banks fail and a debt-spiral collapses debtors, then banks, then financial systems, then governments (this is, in fact, how the Nazis came to power).
There’s a strange corollary to this whole scenario. Even with lower wages, the economy as a whole is better off. And the price of an ownership share (like a stock) has risen by 110%. In our hypothetical situation, the central bank would be torn between cries against wage deflation and howls against financial inflation & speculation. They are feeding the bubble! They are helping the rich! And this is in a scenario where our central bank didn’t even try to inflate wages – it just let things lie. A wage-inflating central bank would push asset prices up even further.
So what is the effect of adding millions of poor Chinese and Indians to the global trading system? More wealth, but not everybody. And the choices for central bank policy?
- Find a middle ground between assets inflating somewhat and wages falling somewhat (where we are now)
- Wait until wages start inflating (while asset prices inflate by far more)
- Don’t let assets inflate past historical averages (which means wages will be forced to deflate, bringing us back to deflation, debt spirals, Nazis)
What this means for investors?
The Federal Reserve and Bank of Japan have learned that #3 is simply not an option. Both are striving towards wage inflation, but ending at wage stagnation. The ECB may finally learn the same lesson (it did start a larger-than-expected round of QE). That said, we should expect asset prices to inflate. We should see stock prices higher. Owners are the big winners in increasing global trade and technological advance. It’s only when wage-earners lose so much that the whole process of trade stops. And that’s when owners end up losing big too. So stop whining about the Fed debasing the currency and become an owner. Just make sure to own the right stuff.