BarroMetrics Views: A Sign of Things to Come
On October 20. China reported a drop in Industrial output from 13.6 to 13.3; and in September China’a inflation rose from 3.5% in August to 3.6%. August had shown a rise from from 3.3% in July. Subsequent to these announcements, the People’s Bank of China (Reserve Bank) raised its one-year lending rate to 5.6 from 5.31 and its deposit rate to 2.5 from 2.25.
The rise of 0.25 was a drop in the ocean in the Chinese context. We can expect to see much steeper rises if China is serious about controlling inflation. The current rise was at best only of psychological value. But there are lessons for us.
Some pundits on the US economy are decrying the warnings of inflation; they say deflation is the danger - pointing to the sluggish job data and sluggish growth. In a sense they are right - until the quantitative easing moves from the banks to Main Street, there will be no inflation danger. But the sheer size of the money created, suggests that when the funds hit the Main Street, inflation will return with a bang. The FED will be forced to raise rates and as the Chinese example is showing, the biggest risk is stagflation.
The last time we saw this was in the years 1966 to 1982.
- 1966 ended with an average rate of 3.01; inflation then rose and dipped from 2.78 to 6.16.
- Then in 1974 it skyrocketed to 11.03, hitting a peak in 1980 of 13.58.
- Three years later the rate was back to 3.22.
- From there inflation fluctuated between 5.39 to 1.55 (to 1998).
The key question is what brought inflation down from 13.58 to 3.22?A: Volker raised the Prime Rate to 21.5% and held it above 12% until Nov 1982. The Prime Rate did not drop below double figures until June 1985.
We need one more piece of info to add to our little scenario - the money supply. The US discontinued M3 reporting but it’s still available from a number of sites, e.g. NowandFutures; unlike ShadowStats, NowandFutures is a free site. Unfortunately we don’t have data for the St Louis deposits before 1980; but the correlation between M3 and inflation is well established.
So what we can say is:
- when quant easing hits Main Street, we’ll see a sharp, exponential rise in inflation. The FED will have to raise rates and we will see stagflation.
- With China already on the skids, this time S-E Asia will not be let off as lightly as it was during the sub-prime.
- The suggested US$500B to US$2T quant easing expected at the next FOMC will do little to ease the current slump unless we see the funds hit Main Street.
One ‘good’ thing, the crisis is unlikely to hit anytime soon. From the time the funds leave the St Louis Fed, we have a 3 to 9 month lead time. So, it’s our job as traders to hone our skills to the best standards we can aspire to. Then, maybe we’ll be able to maximise the opportunities these times will bring.
FIGURE 1 M3
Chart through the courtesy of NowandFutures
FIGURE 2 FRED
Chart through the courtesy of the St Louis Federal Reserve
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