Consuelo Mack WealthTrack – August 12, 2011
Financial Thought Leader James Grant explains why he believes the Federal Reserve’s easy money policies will wreak havoc on the economy and markets. The dangers of inflation creep and how to protect yourself against it are the focus of this week’s Consuelo Mack WealthTrack.
CONSUELO MACK: This week on WealthTrack, while Federal Reserve Chairman Ben Bernanke reassures us that “inflation is not a problem,” our Financial Thought Leader guest strenuously disagrees. Author, historian, columnist and contrary-minded editor of Grant’s Interest Rate Observer, Jim Grant, on why even a little inflation is a dangerous thing, next on Consuelo Mack WealthTrack.
Hello and welcome to this edition of WealthTrack. I’m Consuelo Mack. Federal Reserve Bank Chairman Ben Bernanke has told us on numerous occasions that we need not worry about inflation and that he views recent increases in commodity prices as “transitory,” and predicts they will “eventually stabilize.” As far as most of us are concerned, stabilization, if not reversal can’t come soon enough. Just about everywhere you look, the cost of basics- food, energy, medical and rent- are going up. Those headlines about record highs being set in commodity prices including wheat, corn and cotton and accelerating prices of oil and gas are hitting home. Gasoline prices at the pump have surged more than a dollar a gallon over the past seven months.
Then there is the purchasing power of our currency. As you can see from this chart, provided to us by crack technical market analyst Louise Yamada, the dollar has been in a two year decline versus the currencies of its major trading partners. Yamada expects the value of the dollar to continue to weaken. But what about the broad measures of inflation? What are they showing? Depends upon which one you look at. The chart we are about to show you comes to us courtesy of this week’s Financial Thought Leader guest. He is James Grant, editor of Grant’s Interest Rate Observer, a self-described “independent, value oriented and contrary minded journal of the financial markets.” It also happens to be a must read among top professional investors. This chart, which Grant titles “Inflation Webcast” compares the government issued consumer price index, which as you can see has been rising gradually since early 2009, to what’s called the “Billion Prices Daily Online Price Index,” a real-time index created by two MIT professors. As Grant’s reported, web-monitored prices jumped by 3.2% over the 365 days ended April 4th, considerably higher than the government’s 2.1% rise in the CPI over the 12 months ended in February. And according to MIT, inflation has picked up considerably over the last six months.
But what really sticks in Grant’s craw is that the Federal Reserve feels that 2% inflation is not only acceptable, but desirable. Au contraire says Grant, who says what he calls inflation creep is downright dangerous. I asked him why.
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JIM GRANT: Well, yesteryear, not so long ago, in the ‘50s and ’60s- that is 1950s and ‘60s- there was a little fashion for the idea of just a little bit of inflation, 2 or 3%, some of these theorists thought, would be just what we needed. It would impart a lilt to our economy; it would make everyone feel a little bit more prosperous. You get up the morning with a little spring in your step because everything was getting higher, and this was called “creeping inflation”, and some of the advocates were of most learned segment of the provisorial class.
So this idea gained wide circulation, and no little credence, but it was met tellingly by the most orthodox central bankers as rank heresy. As a fellow of the Atlanta Federal Reserve, in fact, the president of that regional Federal Reserve Bank named Malcolm Bryan, and Malcolm Bryan regarded the premeditated creation of inflation by the Fed as an act of moral affront. It was a sin in his view, and he spoke in terms of… he spoke it with almost an evangelical fervor against it. So fast forward to the present day, which is not so far forward in the scheme of time, and creeping inflation by another name has been instituted as official policy. We call it “inflation targeting”. Monetary masters seek 2% a year, which in their self-delusion, they think they can deliver.
CONSUELO MACK: So what is wrong with a little inflation, and especially given the fact that we’ve just gone through a period of financial crisis, as a matter of fact, where inflation– there were eight consecutive months at one point of declining prices, and if the Fed’s, one of the Fed’s primary mandates is price stability, if, in fact, prices are declining, don’t you want to goose the pump a little bit, or prime the pump, and actually get prices so they’re relatively stable?
JIM GRANT: Well, I think one thing to ask is what do we mean, or what should we mean by this phrase “price stability”, which is so often heard and glibly spoken? And let us suppose that the modern world has delivered a kind of cornucopia, that with the addition of 200 or so million willing new hands in one country in Asia, and another couple of hundred willing, new eager hands, another country that the world’s labor force expands, that digital technology further makes us productive, and that the world supply curve, as the economists say, shifts benignly, that is to say at a given level of prices, there is more stuff for sale. More things more cheaply priced is, in fact, what you find when you walk into Costco or Wal-Mart. I’m astounded at the sheer volume of merchandise and its accessibility. So that’s one observation.
So that’s every-day low prices, right? It’s every day low and lower prices. Explain again, Mr. Fed, what’s wrong with that, is what many Americans spend all weekend looking for, right? And we are meant to understand our Fed, experts tell us, that this is somehow dangerous. So I would ask us all to reconsider if stable prices in a time of rising productivity growth and of profound historic expansion of the world’s productive apparatus, if stable prices ought not to mean Wal-Mart kind of every-day low and lower prices. So I think the Fed I think does not believe that. So to give us stable prices, it would have to create more credit to compensate for the Wal-Mart effect in retail, right? So it’s creating the dollars with which to lift the price level from what it would otherwise be, and in so lifting, it affects a widespread distortion of prices and structures in the economy.
CONSUELO MACK: But Jim, the other side of that Walmartization of consumer prices, and I can see that is considered to be a good thing, the other side of that is the Walmartization of wages. Address the issue of wage deflation.
JIM GRANT: It’s hard to find good work at a good wage, and a lot of people in this country are hurting, and it will be of little or no comfort then to know that their lot has frequently been the lot of people in a time of great economic and technological upheaval. Late in the 19th century was a time much like ours in that it was a time of almost miraculous advances and productive technology. Just imagine how much more efficient the world suddenly became with the advent, for example, of electricity, telephone, and telegraph. It was a world of wonder, and in this world of wonder many people were displaced from work; fewer people were necessary to produce what had been produced before these advances in technique and technology, and the people who were displaced had to find something else. They found it, and society moved on, the country improved, got richer. We are phenomenally richer than we were then. Again, this is a little sermonette that will please no one who is looking for– you know, this is not to patronize anyone who is suffering by saying that before you, have others gone just like you, but that happens to be the fact.
CONSUELO MACK: Let’s talk about inflation, and the fact that you were talking about this inflation creep, which you believe is dangerous, and the fact is that the Federal Reserve, and Fed Chairman Ben Bernanke, has targeted, and quite openly said that he’s targeted 2% inflation, and that they, the Feds, seem to feel, and a lot of the financial community seems to feel as well, that 2% inflation, it’s benign, and that inflation really isn’t an issue, and they don’t see any signs of inflation. Man, woman on the street, I see lots of signs of inflation. Are the statistics wrong, is their interpretation wrong? I mean, what do you think the given inflation rate is right now?
JIM GRANT: Sometimes I think that our experts make an easy thing hard. I would define inflation not as too much money chasing too few goods, which is arbitrary, but too much money, and the thing that the redundant segment of money chases, varies from cycle to cycle. It could chase skirts during the inflation of the ‘70s when everything went up at the cash register, or it could chase stocks and bonds as in our own day when the form of inflation is called a bull market, a very pleasing form of inflation on Wall Street. But the process of creating more money than is demanded for productive enterprise is inflation by any other name, and the form that it takes, as I say, is variable. And today, we don’t have to look too far to see many forms this inflation takes. The shiniest skyscrapers in our most prosperous coastal cities are priced as they were at the peak of the real estate lunacy of 2006 and ’07 all over again.
CONSUELO MACK: Which was news to me, but that’s an astonishing fact.
JIM GRANT: Commodity prices we know about- new highs in gold, new highs in silver.
CONSUELO MACK: Farmland and …
JIM GRANT: … farmland in Iowa. Grundy County farmland is now, some of these transactions are taking place at $10,000 an acre, which translates into some of the lowest rental returns on record for lease 40 years. So the Fed, I think, is unconscionably complacent about the consequences of what it’s doing, and let us not blink at what it’s doing. It has imposed the lowest money market interest rates that anyone remembers, and indeed, they could hardly go much lower, they being at zero. It has expanded its balance sheet into something grotesque all in the space of a couple of years. You know, these are monetary events that have never before been seen, and indeed, never before imagined.
CONSUELO MACK: The Fed Chairman would say and has said, and what much of Wall Street has said as well, is that the Fed needed to take dramatic action in a dramatic time, and in order to basically, you know, bail us out of an unprecedented financial crisis, or something not as great as we’ve had since the Great Depression, that it needed to do all of these things; and isn’t it great, in fact, that we’ve recovered to the extent that stock and bond prices are going up, and commodity prices are going up, and that, in fact, you know, is a good thing for people who work in those industries, and the household wealth of…
JIM GRANT: Well, Consuelo, you’re right, they do say that, they do say that, and it is certainly great for one class of society. It’s great for the speculative classes. In private testimony before the financial crisis inquest, Ben Bernanke, the Fed Chairman, he said, “I, speaking as a scholar of the Great Depression, I’ll tell you, that the events of 2008 were, in fact, the worst financial crisis is in American history, period. Twelve out of the thirteen largest American financial institutions were on the brink.” Now, we ought to stop and ask why that was so, if it was so. Let’s say it was. Our GDP was down less than 4% top to bottom during our Great Recession. During the Great Depression, our GDP was down in nominal terms, that is to say dollar terms, was down not quite, but almost half, yet most banks did not fail during the Great Depression.
During our piddling Great Recession, by contrast, we hear from the regulator and chief that we’re at death’s door financially, so something has happened to our financial institutions and to our way of doing business, which I think speaks to the monetary arrangements we have elided into. We have socialized risk, we have privatized gain, much to the relief of Greenwich, Connecticut, where our zillionaires live, and the unconscionable and indefensible fallout of this is that savers get zero on their savings balances, and the speculative classes get to borrow in wholesale markets at zero, and make their zillions all over again in commodities, stocks, and bonds. So I think that the Chairman is whistling by the graveyard, and he’s whistling by the graveyard in this matter of a 2%inflation rate being harmless.
CONSUELO MACK: And let’s put some numbers to that harmlessness of the 2% inflation rate.
JIM GRANT: Let’s talk about the Federal finances for a second. In the past five years- I’m using round numbers- the Federal debt is gone from quote $5 trillion to almost $12 trillion, yet during that period, thanks to these little miniature interest rates the Fed has imposed, the interest bill on the public debt has risen hardly at all. The government is paying like 2% plus on these trillions of dollars of indebtedness, and as percentage of federal outlays, interest expenses, like 6 ½ %, it is the lowest it has been in decades.
So if interest rates were to go back to where they customarily were, where they have been for the past five decades, say between 4 and 6%, our interest expense on this debt is going to be enormous. So people who say, “Ah, thank goodness for our federales, thank goodness for our masters in Washington, they rescued us from ourselves.” Well, yes, in a way, but the consequences of this rescue are enormous morally; let us not forget, financially and fiscally, and we haven’t finished reckoning them yet. They’ve barely started reckoning them.
CONSUELO MACK: I was going to ask you, so what are your inflation expectations?
JIM GRANT: So my expectation about inflation is that there will be a lot of it suddenly, and by a lot of it, I mean something that people can’t explain away, that the authorities can’t explain. I say 4 or 5%, let us say. So think about what that would mean. So much of our speculative apparatus is powered on these 0 percent interest rates- hedge funds, and the professionals who borrow…
CONSUELO MACK: Because that’s what they can borrow at, right.
JIM GRANT: Yeah. Why wouldn’t you? I can’t blame them. So they’re borrowing at nothing. Banks are paying nothing on deposits, so banking margins are fat. You know, we are back to rates of return in banking capital we haven’t seen before. We are about on the verge of all-time highs and bank profits thanks in part to this uniquely, this unusually– I use “unique” a little too loosely. Nothing is unique in finance. This astoundingly twisted interest rate structure. So much of the structure of values and prices in financial markets are based upon an interest rate structure that is, you know, beyond strange, and it certainly can’t be supported forever.
CONSUELO MACK: Tell me what this means as far as our investment, investment strategy is concerned.
JIM GRANT: Nothing is going to be good. So think how hard it is to hold back a cash reserve in this time, when cash yields nothing, it yields a negative because the inflation we all see is something more than zero, right? Cash yields zero. That’s hard. It’s doubly hard because your stupid neighbor who doesn’t watch this program is making a lot of money in the stock market. How hard is that not to participate… you can’t not do it.
CONSUELO MACK: Just like the housing market a couple years ago.
JIM GRANT: Right. But stop and think what it would mean if there were 4%, a persistent and undeniable, you can’t explain away this 4% inflation rate. It would mean that the Fed would clear its throat and say in the marble mouth way it speaks, the party is over.
CONSUELO MACK: Right. And they do it pretty quickly.
JIM GRANT: So suddenly, you know, the commodity markets have been the great haven for inflation-fearful people. I don’t think they do very well in this moment of reconsideration of interest rates and leverage. So suddenly everything would fall out of bed, I think. I think gold would ride itself, silver would ride itself because their money, I think, would come into their own at the end of the cycle of disillusionment. But for a time, I think there would be terrific chaos in investment markets, meaning terrific opportunities. People would be selling stuff they shouldn’t sell, so people with liquidity, which again, pays nothing and is impossible to hold when your friends are getting rich without it. The liquidity would come into its own very suddenly.
CONSUELO MACK: So cash would no longer be trash…
JIM GRANT: Right.
CONSUELO MACK: …cash would be precious and valuable.
JIM GRANT: It would. Yeah, even dollar bills, which I’m in a habit of disparaging, because they’re paper.
CONSUELO MACK: So, Jim, the gold standard. You’ve been an advocate of a gold standard for a long time.
JIM GRANT: Yeah. I was an advocate of the gold standard when there actually was a gold standard, in 1914. It would take a terrific collective rethink, and it would take a great unfrocking of the authorities and the experts who now not only, who don’t even disagree with us. It’s worse. They don’t just say, “Grant, you’re wrong”, they say– it’s a smiling condescension one can’t stand.
CONSUELO MACK: Right. They dismiss it.
JIM GRANT: Right. Sorry, right. But I think, if I’m right, and I think I am, if I’m right about the dynamics of the Federal debt, if I’m right about the absence of a check on our continued running of the most profligate deficits, and if I’m right about the social and political immorality of monetary arrangements as they now exist- that is to say savers getting nothing, and the speculators getting most everything- it seems to me not only is the mathematics of a gold standard compelling, but also the politics are compelling.
CONSUELO MACK: So, Jim, you have in the past, when you’ve been on WealthTrack and in other places, have bemoaned the fact that you are viewed as a bear, because in Grant’s Interest Rate Observer, you always have a long idea, and usually have short ideas, as well. So what’s your long idea?
JIM GRANT: I’ll tell you what we’re looking at right now, we’re looking at commercial real estate. What is new and what is really interesting about the commercial real estate market these days is there is enormous spread in returns between what is popular and liquid, and shiny, that is so-called trophy properties in the big cities, that’s on the one hand, versus less liquid, more out-of-the-way properties outside–
CONSUELO MACK: Tarnished?
JIM GRANT: Some of them tarnished, but some of them are just plain fine, but they are not at the corner of Park Avenue and 54th Street. So an office property recently changed hands in Milwaukee, the first such sale in a year, such as the ill-liquidity of the commercial real estate market. It changed hands for a cash on cash return without financial leverage of 8%. This is fully leased, ten years, one tenant, sounds like a pretty substantial property, and 8% versus the 4 or 5%. Increasingly 4% you get on these core properties. So we intend to do a great deal more digging, and try to surface investments that offer good valuations now, and that offer some inflation protection because rents will escalate as the cost of living goes up. So that’s our new idea.
CONSUELO MACK: So what is an accessible investment for individuals, for instance, who can’t buy a building, a commercial building?
JIM GRANT: There was a great income famine in the world, right? You can’t get any return on your savings. You look around, even junk bonds have junky yields.
CONSUELO MACK: Right.
JIM GRANT: High yield isn’t high yield, high yield is low yield. So what to do? So I own this personally, for whatever it’s worth. I’ve been friends forever with the management, I think they’re solid people, something called Annaly, N, as in Nancy, LY is the ticker–
CONSUELO MACK: And we know, we’ve had Mike Farrell on the founding of the CEO–
JIM GRANT: It trades around book value, it yields something in the teens, it buys mortgages with borrowed money. The leverage is conservative as mortgage real estate investment trust. Leverage is reckoned. These people have been through the cyclical mill, they have seen what it’s like to have been on the wrong side of too much leverage, and I think they’ve had the fear of God instilled in them. So they yield in the teens.
So how to get income if you’re an individual. Well, you can go out and buy REITs, yield say 5 or 6 %.You can go out and buy dividend-paying stocks that yield 2 or 3 %, and the stocks are priced reasonably at 15 times earnings. You can go out and buy municipal bonds that yield 3 and 4%. Some of them aren’t so bad, some of them are, in fact, quite good. The municipal bond market is immense. You can get some comfort, a credit quality in municipal bonds. But to do all those things, you’re not talking about a great deal of income.
My idea is that perhaps one goes out and buys rather more of Annaly, and rather less of the other things, keeps a substantial cash reserve for that moment, which I think is coming, in which the realization of a new inflation cycle shakes up valuations and prices across the broad spectrum of financial assets, and you have the liquidity ready to take advantage, to buy things on the cheap.
CONSUELO MACK: Jim Grant, it is such a treat to have you on WealthTrack again.
JIM GRANT: Consuelo, thank you. I’m so delighted to be here.
CONSUELO MACK: It is not only a pleasure to talk to Jim Grant, it is also a treat to read him. He has a new book that just came out, called Mr. Speaker!: The Life and Times of Thomas B. Reed The Man Who Broke the Filibuster. As one reviewer put it: “No period in American history is more colorful or relevant to our own- for better and worse- than the Gilded Age. James Grant brings it all memorably to life.”
Next week we’ll be talking with Great Investors Tom Russo who focuses on companies with the best global consumer brands and Royce Funds’ David Nadel who invests overseas in dividend paying small cap firms. .
To see this program again please go to our website wealthtrack.com, and while you are there, check out WealthTrack Extra, where you can watch the complete interview with the fascinating Michael Mauboussin of Legg Mason Capital Management, who has some unusual insights into investor behavior. Thank you for taking the time to visit with us and make the week ahead a profitable and a productive one.