Jewish World Review Dec. 5, 2002 / 30 Kislev, 5763
David R. Kotok
Five easing pieces
http://www.NewsAndOpinion.com | Five forces insure that a general deflation will be avoided in the United States.
Inflation and deflation are both in the nominal realm. They result from policies which effect nominal prices. The five forces now at work are designed so that inflation will prevail over deflation.
This means that the nominal prices of goods and services and certain assets (including stocks) should respond by rising. It also means that a gradual upward trend in the indices which measure inflation should be visible in 2003.
This is good for stocks but bad for bonds. Bond prices will be under pressure as inflation reappears and interest rates rise. Markets are already adjusting to this expectation.
The five forces are:
1. Monetary stimulus. Here the evidence is compelling. Fed Funds now yield less than most inflation measures. The Fed has declared itself with clarity; see "Lessons Learned at the Philly Fed" http://www.cumber.com/comments/112502.htm.
2. Fiscal stimulus. Our budget deficit is worsening. We now expect the deficit to cross the 2% of GDP threshold within one year and trend toward 2 1/2% or even 3%. Fiscal discipline is gone. Much added spending is for increased security and defense. That means more federal employees. This hiring will offset the deteriorating pressures we have seen in private sector employment during the last three years. Total employment will be headed up in 2003; so will the aggregate incomes of those workers. We look for a peaking in the Unemployment Rate during the first half of the year.
3. Tax cuts. Some are already in the law. More are coming. President Bush now has the congressional alignment he needs to advance a tax cut package. That will enlarge the deficit but also stimulate the economy in a positive and real way.
4. Weaker dollar. We will never see an official statement about a weak dollar policy. That would create a riot in the currency markets. We will see U.S. policy ignore the currency. Officials hope for a benign decline in our currency's value on a trade weighted basis. This is the major uncertainty facing markets. Whether this adjustment happens in an orderly way remains an open question; however, orderly or not, a weakening currency is now part of the U.S. strategy to avoid a deflation.
It is this realm of currency which holds the greatest danger for our markets. The Fed can control the short term interest rate and the value of our currency. It cannot do both at the same time.
5. Structural credits are now advancing in the international arena. This is a complete reversal of American policy from only one year ago. Credit to Brazil, Uruguay and others are evidence of this change. Remember that little happens in the International Monetary Fund or other agencies without the U.S. agreeing to it. We now expect that even the most intractable credits will be refinanced. A forecast: Argentine debt will be rolled over.
These five forces impact the nominal sphere by making it easier for prices to rise (currency value fall). They can benefit the real economy to the extent they ease the burden of debtors (through inflation) and offer incentives for capital spending (Bush's tax policy). Results will appear in real side of the economy in 2003 but will be mild.
Remember, most of this stimulus effects the nominal and not the real. Changing prices does not remove excess capacity; it still has to be worked off.
All this means the Cassandra-like forecasts of economic growth are too low. Some are forecasting a flat 4th quarter GDP. Nope. We expect it to be closer to 2%. Next year should see something above trend and closer to 4%. Add a 2% and rising inflation rate and we will see a 6% increase in nominal GDP. That's over 600 billion in nominal measure which should translate to an increase of 35 to 40 billion in nominal after tax economic profits. This is bullish for stocks.
All forecasts come with a guarantee of course: it works like this. We give the forecast. You hold it for a year.
Then you bring it back so we can check it out. We guarantee you that we will give you a new one.
11/26/02: Lessons Learned at The Philadelphia Fed … and an update to our strategic outlook