There should be a double bonus for Australian financial stocks today. First, American financial shares rallied overnight. The shares of Wells Fargo, the fifth largest bank in the United States, were up over 33% after the bank raised its dividend by ten percent and said its revenues were up 16%.
That’s the kind of lead that should be good for the local market. And then there is that speech Glenn Stevens gave yesterday in Sydney.
Stevens said that higher interest rates look like they’ve slowed down demand in the Australian economy. As a result, “It looks more likely now than it did a couple of months ago that this more moderate track for demand will continue,” and that it would “in due course begin to exert downward” pressure on inflation.
The papers loved it. “RBA boss hints at rate cute,” reports the Age. “Australia winning battle against inflation,” reports the Herald Sun. “Reserve may cut rates despite ‘high’ inflation,” says the Canberra Times. We are told that even a big CPI number on July 23rd won’t worry the RBA too much, now that the fight against inflation appears to be won.
We are going to ask an obvious question. Sometimes the obvious is so obvious that everyone ignores it. But we feel compelled to be obvious this morning and are not afraid of looking stupid for challenging a basic assumption. It wouldn’t be the first time.
Does the Reserve Bank (and the bulk of the Australian financial press) believe that consumer demand causes inflation? If so, it is either a deliberate deception or monumental monetary stupidity. Let’s unpack that, as Dr. Phil might say.
If you think that rising demand causes inflation, the sensible thing to do is reduce demand. You do that by raising interest rates. The higher cost of money causes people to cut back borrowing and be more prudent. Aggregate demand in the economy falls, and, presumably, so do prices.
But that is all catastrophically backwards. It is a text book cause of putting the cart before the horse. In simple terms, it is a faulty definition of inflation. Inflation is not “rising prices.” More on this crucial point in just a moment.
While we’re on the subject of inflation, both consumer and producer prices in the U.S. blew out this week. Big time. Uh oh.
Wholesale (producer) prices in the U.S. grew by 9.2% over the last twelve months, according to data published yesterday by the Commerce Department. It was the fastest 12-month growth rate in 27 years. And today, we learn that consumer prices are rising, too.
Consumer prices for food, fuel and other things people actually buy rose by 1.1% in June. But over the last twelve months, the rate is more like 5% (and probably much higher than the official figures suggest). It’s a shame if you’re living on fixed income in America these days. The Fed is plundering the value of your savings to bail its buddies in the risk-mismanagement business. Too bad.
However, the bad news for savers kicked of a perverse rally in the U.S. dollar. P-day will have to wait. Ignoring the actions and words of the Fed, some traders apparently believe the higher inflation figures mean the Fed is more likely to raise rates this year, making the greenback a bit more attractive than it currently is (how much uglier can it get?)
The merest possibility of a rate hike, plus the good news from Wells Fargo, sent the Dow up 276 points. The money centre banks (Wells Fargo, J.P. Morgan, Citigroup, Bank of America) were all up, with the industry index itself climbing by 16%.
Here’s some more obvious free advice: Don’t be fooled by the fake-out rallies. The big money centre banks are unlikely to fail. Why?
Well, take a look at who’s on the Board of Directors of the New York Fed and you’ll see why. The big American banks won’t be allowed to fail because they ARE the Fed. The smaller banks that have GSE debt on the balance sheet (but don’t have friends in high places) aren’t going to fare as well.
Even though we expect the money centre banks to look out for each other (via the Fed), there are signs of dissension in the ranks among the Wall Street elite. It’s kind of fun to watch. We read yesterday that Lehman’s CEO Richard Fuld is rumoured to have confronted Goldman Sachs CEO Lloyd Blankfein over even more rumours that Goldman traders were disseminating bogus information on Bear Stearns and Lehman to make a profit.
Now that could ever happen, could it? It would be illegal to profit by knowingly circulating false or misleading information. We can’t imagine anyone in the investment banking business doing it.
Yes, internal quarrelling is a sure sign that Wall Street is really worried about its model. It’s like watching a bunch of high school cheerleaders gossip about who’s cheating on who’s boyfriend. Normally these institutions are united in their Olympian disdain for the individual investor. They are now divided over their mistrust of one another.
To modify an ancient phrase, “Those whom the gods wish to destroy they first make envious.”
Now, about this inflation issue.
If you navigate your way to the Glossary of Terms and Definitions at the Reserve Bank’s website, here is how you’ll find the word inflation defined:
A measure of the change (increase) in the general level of prices.
That is simply wrong. But rather than acting like a school teacher about it, we’ll give you an example of why this definition mistakes an effect for the cause.
Let’s say you’re in a bar having a quiet drink. Next to you is a man drooling on his chicken parma. He later rouses himself and turns to make conversation with you, only his tongue is so thick you can’t understand anything he’s said. Much later, he strips naked and dances up and down the length of the bar, shouting that the Dow is going to 20,000. After the police come and arrest Jim Cramer, they ask you a few questions.
“Did you know the suspect was drunk because he couldn’t hold his head up?”
“Did you know the suspect was drunk because he danced a jig in your mashed potatoes?”
“Did you know he was drunk because he claimed the Dow was going to 20,000?”
“Then how did you know he was drunk?”
“Because I saw him drink eight beers, three shots of vodka, and a purple hooter.”
“You mean you knew he was drunk because he’d consumed too much alcohol?”
Inflation is caused by an increase in money supply. Rising prices are merely the effect of the increased money supply. You wouldn’t blame rising prices on excess demand any more than you’d attribute a man’s drunkenness to his behaviour. The effects cannot be the cause.
-You don’t cool inflation by cooling demand. You cool inflation by making sure the growth in the money supply does not exceed the growth in the economy. When money supply growth exceeds real growth in goods and services, prices are going to rise. It all begins with the artificially adjusted supply of money.
Simple price rises are not inflationary. For example, with low unemployment in Australia, wages are going to rise. This is a simple case of supply and demand, and doesn’t have as much to do with the supply of money. But rising prices don’t always indicate inflation. You get inflation when the money supply expands, plain and simple.
For years in Australia, money and credit growth has exceeded GDP growth. This is what causes inflation. The RBA knows this. It published the graph below. What do you think it means?
The RBA says that, “Broad money is defined as currency (that is, notes and coins held by the private non-bank sector) and highly liquid assets held at financial institutions by the private sector, including deposits, cash management trusts (CMTs) and certificates of deposit (CDs).”
You can’t make this stuff up. It is what it is. The Bank erroneously believes that inflation is a rise in prices. But a rise in the general level of prices can only occur if there is first a rise in the money supply. And as you can see, the Bank knows full well that broad money has been growing at double digit rates for years, most recently at 17%. It should not come as a surprise then, that prices are rising. But you can’t blame it on consumer demand. Inflation begins and ends with money supply growth.
Just exactly why governments pursue systematic inflationary policies is another question. And it’s not just an economic question either. It’s partly moral and partly philosophical and somewhat diabolical. More on that tomorrow. And by all means, if you believe we’ve made a mistake in our interpretation or mischaracterised the RBA’s definition of inflation, let us know at email@example.com.
for Markets and Money