Political Uncertainty Will Stave Off Inflation

With today’s positive ISM report and the December equity market mini-rally, it may seem that we are out of the woods. 

While many on the Street are forecasting levels of 1450 and above for the S&P 500, I don’t buy it.  Nor do I see a rate hike anytime soon. 

Near term inflationary fears do not seem completely justified. There are two salient metrics that should not be overlooked:  the M2 velocity is still low, and personal savings is still high.

Given this, it’s unlikely we are going to experience surges in GDP, aggregate demand, or consumption anytime soon. 

In the long run, prices will respond proportionally to an increase in the money supply.  The rules of economics will inevitably rear their ugly head at some point; but despite what many believe, the inflation can has been kicked down the road for at least a year.  Given all this, it is unlikely that we would see a Fed raise before February of 2012.   

The rationale for this theory rests on the assumption that inflation will not occur until unit labour costs rise, and wages will not rise until there is less competition for jobs.  Unemployment was observed at 9.8% in November 2010.[1]  This is likely grossly understated, if we take into account the myriads who are underemployed, or who have simply given up searching.  Total spending is simply too low to employ the entire labour force, and despite all the expansionary monetary policy, joblessness is still too high to go away anytime soon.

One fact that many overlook is that the velocity of M2 Money Stock (M2V) was last observed at 1.7.[2]   Velocity describes the turnover rate of money, giving us a sense of the number of times one dollar buys a final good or service while it circulates in our country for a year.  Personal saving as a percentage of disposable personal income was 5.3% in November.[3]  You can lead the horse to water but you can’t make him drink.  It doesn’t matter if the Fed enacts QE #555.  The two major drivers of buyer behaviour are still fear and greed.  Inertia will prevail until fears abate.

While the technical ailments plaguing our country are obvious, perhaps the intangible factor that is being overlooked is the sense of worry over political uncertainty.  American businesses, big and small, aren’t sure if President Obama loves or hates them.  Working class Americans aren’t sure if they will have health insurance.  Wealthy Americans aren’t sure if they are going to become pillaged by high tax rates.  Retired Americans would love to make more than 0.25% on their savings, but they aren’t sure the muni market is not going to collapse.  Every other day, we are bombarded with news about Spain being on the verge of caving in and the US becoming inflated like Weimar Germany…or, maybe on the other hand, deflated like Japan.  We turn to our leaders for guidance, but the politicians in Washington are stuck in gridlock, stirring every so often to engage in a Kabuki dance.  Things are as clear as mud.  No wonder inertia persists.

It doesn’t seem like meaningful growth can happen in this environment, no matter how much the Fed activates the printing press.  2011 will likely be another gut wrenchingly volatile year, and the roller coaster ride will probably end much the same as this one did: tepid, 10-12% returns for the equity market, with investors fleeing to bonds, cash, and gold.  Inflation and rate hikes do not seem real a real possibility anytime soon.


 [1]Unemployment data from Bureau of labour Statistics, December 2010.  Pertains to adults 16 years of age and older. 

[2] M2 Statistics from Federal Reserve Bank of St. Louis, December 2010, observed for Q3 2010.  


[3] Bureau of Economic Analysis, November 2010 Personal Income and Outlays

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