The Wall Street Journal released its Semiannual Economic Forecasting Survey for the second half of 2004 yesterday. In summary, economists see better times ahead and are not concerned that rising interest rates or inflation are going to crash the party. They expect economic growth to increase and unemployment to decrease.

Sixty percent of those surveyed see inflationary pressures dissipating during the balance of the year. More than half blame the increase in inflation on higher energy and commodity prices, yet only four percent believe that weakness in the dollar had anything to do with the inflation. The latter are the only ones that realize both energy and commodity prices are up (in US dollars) predominantly as a result of the decline in the dollar. It makes you wonder about the other ninety-six percent.

When the dollar declines on foreign currency markets anything the US imports, or anything that is priced on world markets, such as oil, copper, nickel, gold, etc., increases in dollar-terms. Not only is it intuitive that commodity prices increase when the dollar declines, it is possible to statistically show that the decline in the dollar has played the leading role in the price increase of almost all commodities.

If inflation is increasing as a result of higher energy and commodity prices then the underlying reason for the increase in inflation has been weakness in the dollar.

Let's be clear about what inflation really is. Nowadays inflation is defined as a general increase in prices, and it's typically measured by the increase in prices of a basket of consumer goods; hence the Consumer Price Index. But if you still have an old dictionary handy, you'll see that inflation used to be defined as an increase in the supply of money. Prices rise as a result of an increase in the money supply, which decrease the value of every dollar. By changing the official definition of the word economists have confused the issue and managed to confuse the majority of people, including themselves.

The broadest measure of money supply in the United States is M3. M3 has increased by an average of 7.93% per year since 2000. Had all else been equal, we should have seen an almost eight percent annual increase in prices. Yet the average increase in the CPI (Consumer Price Index) has been only 2.1% since 2000; why has it not been closer to eight?

The application of hedonic calculations (yes, hedonic is an official economic term: it's when the intrinsic quality of an item is taken into account when evaluating its price) to the CPI has rendered the Index dubious at best. I would suggest you check your monthly grocery bill and estimate by how much it has increased since 2000. According to the increase in money supply the same groceries you bought in 2000 should cost you about thirty-six percent more now, and according to the CPI they should cost less than nine percent more. I suspect you'll find the truth somewhere in between, but much closer to thirty-six percent than nine percent.

Other than a decrease in money supply, circumstances within the economy could cause a general decrease in prices. Let's take the reversal of the wealth effect as an example.

During the Nineties, US consumers went on a spending binge. When they couldn't buy any more they borrowed money and bought some more because they felt wealthy: they were making money in the stock market, in the bond market and in real estate. This is called the wealth effect.

I mentioned (in previous columns) the detrimental impact higher interest rates and a lower dollar would have on the US economy. If I'm right, then US consumers will, during the next five to ten years, lose money in the stock market, lose money in the bond market and even perhaps on their homes. This is not going to make them feel wealthy and is therefore unlikely to stimulate the kind of consumerism that we have seen during the past two decades. And a decline in consumption can put downward pressure on prices.

So how do we reconcile a decline in prices from a lack of consumer demand with an increase in prices as a result of monetary inflation? Will we see inflation (of prices) or deflation? I think we'll see both.

The increase in energy and commodity prices will put upward pressure on just about everything. So we'll see increases in gasoline prices (already happened -- check), increases in food prices (check), and, basically, increases in the prices of most necessities.

But as discretionary spending subsides, the decline in consumer demand will put downward pressure on the prices of those things that are not necessities. Therefore we'll see a decline in prices of big-ticket items and capital goods, like automobiles (check). First there was 2.9% financing, then zero percent financing, then zero percent financing or a cash rebate. Now you can get zero percent financing and a cash rebate, and yet Ford has just announced that its June vehicle sales fell almost eight percent because of a double-digit decline in passenger vehicle sales. So much for the economic recovery...

I wrote an article about the economic recovery on January 30 ("The Greater Depression"), I suggest you read it if haven't yet done so. Compare that with the Wall Street Journal survey that says all is well, that inflation is going away during the next six months, that the economy is not only going to continue to expand but actually expand more rapidly, that the dollar is in good shape and stocks are a safe bet.

Fifty-three percent of the economists polled expect stocks to remain where they are or move up slightly and forty-five percent expect stocks to move up significantly. Only two percent expect stock prices to decline. It was interesting to note that fifty-eight percent of the economists had more than fifty percent of their savings in the stock market and seventy-six of those said that their stocks were up from a year ago. I wonder if any of them own gold stocks, because the NYSE Composite Index is only up 2.5% over the past twelve months.

I think I'll stick to my junior exploration stocks. If I had to make a bet, I'd say that the guys who run the companies I own know more about their businesses that the economists who were polled by the Wall Street Journal know about economics.

Paul van Eeden
www.paulvaneeden.com

(Article originally published here).

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© 2004 Paul van Eeden

ABOUT THE AUTHOR

Paul van Eeden is well known for his work on the relationship between the gold price and currency markets. Originally from South Africa, he has an international perspective of markets, and gold in particular. In addition to his expertise in gold, Paul van Eeden has an insider's understanding of mineral exploration, having been intimately involved in the financing and evaluation of resource companies since 1995. He writes a weekly newsletter about his company's investments and a weekly commentary on markets, the economy and other investment related topics. Paul van Eeden is a frequent speaker at numerous international investment conferences and a regular guest on radio and television shows across the globe.

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Posted in Current Events, Monetary Commentary, Guest Commentary, Paul van Eeden