Inflation or Deflation?
The economic indicators point to deflationary threats in the near term, and inflationary threats over the long term.
The Present Danger Of Deflation
"There is the possibility … that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control." - John Maynard Keynes, The General Theory
"Indeed, there is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral." - Alan Greenspan, 2003
"It is also interesting to see how government bond markets are reacting to the oil price surge -- by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock." - David Rosenberg, 2011
Economists define inflation as "too much money chasing too few goods and services." You'll notice that there are three parts to this definition being the "too much money" part, the "chasing" part, and the "too few goods and services" part. We know that governments through quantitative easing have created "too much money." However, consumers are not "chasing" goods and services because of unemployment, under-utilized factories, fear and uncertainty, bankruptcies, over-indebtedness, stock and real estate asset depreciation, and higher levels of frugal retirees. Without consumer spending, prices and wages fall and economic growth declines. In addition, because of the low costs of global labor, the global economy (especially China) created excess capacity by overproducing their products and overbuilding their factories. What happens when you have "too much money," "too little consumption," and "too many goods and services"? Near-term deflation and long-term inflation.
In Bernanke's 2002 speech about deflation, he states that the Fed could put a ceiling on interest rates by having the ability to make unlimited purchases of securities that are two years from maturity. He also argues that the Fed could offer zero percent loans to banks based on restricted asset classes (including auto loans, commercial paper, bank loans, mortgages, and corporate bonds) for collateral. Bernanke's speech became known as the "Bernanke put" and many bond investors believe that they can buy bonds without fear of value declines because the Fed would step in and buy bonds to keep interest rates low.
For over a decade, the world experienced deflationary pressures caused by $4/day labor. This fact was deeply hidden by the booming asset bubbles in the real estate and stock markets. When the stock market crashed in 2008, we saw a sharp drop in prices (as seen in the graph on my blog at http://zempower.com/archives/713), which explains why the Fed started QE1 (November 2008 to March 2010) and QE2 (November 2010 to March 2011).
Source: Bureau of Labor Statistics
QE1 and QE2 seemly accomplished the target of devaluing the dollar and causing oil and commodity prices to rise. Although gas prices rose by 4.7% in February 2011, according to the U.S. Bureau of Labor Statistics the Consumer Price Index for All Urban Consumers (CPI-U) increased only 0.5% on a seasonally adjusted basis. Interestingly, recent data shows that commodity price increases have not been passed by businesses to their customers. With Fridays reporting showing unemployment levels at 8.9% and the Thomson Reuters/University of Michigan consumer sentiment index dropping to 68.2 in early March from the end-February reading of 77.5, businesses seem reluctant to increase their prices while raw material prices continue to rise.
The upward trend in the consumer price index makes it sound compelling that the deflation threat has passed, but don't forget that quantitative easing added $2.1 trillion to the economy. What happens now that QE2 has officially ended?
The economic indicators that point to slow GDP growth and deflation include 1) data showing high levels for inventory liquidations accounting for 60% percent of real GDP growth in the five quarters through the third quarter of 2010; 2) excessive inventories in the housing market; 3) falling state and local government spending and payrolls; and 4) a net fiscal stimuli that is decreasing by $100 billion. In addition, events that could trigger a market crash that would cause deflation include 1) the sovereign debt crisis in Europe; 2) a correction in the commodities market; 3) correction in the China boom leading to Chinese bank failures; 4) a correction to the current account deficit; and 5) a global recession caused by slumps in export-driven nations as a result of dollar depreciation.
Long-Term Inflation Threat
It's not difficult to surmise that the Federal government's fiscal deficits and the Fed's quantitative easing will lead to long-term inflation. When central banks, hedge funds, private equity funds, and sovereign wealth funds take flight from the dollar, the exchange rate depreciation will cause food, oil and other commodity prices to rise.
Similar to the 1960s where we saw both militarism leading to the Vietnam War and liberalism in Lyndon B. Johnson's Great Society, the fiscal failures of the US government caused by militarism and liberalism in the last 10 years resembles the 1960s. In the "great inflation" of the 1970s, poor fiscal policy on the part of government led to escalating interest rates and a reluctance from capital investors to commit funds to infrastructure development. For example, three month treasury bill yields averaged 5 percent in 1976, 5.3 percent in 1977, and 7.2 percent in 1978. By June 1979, the yield was 9.1 percent but, by early April 1980, it had jumped to 14.8 percent. Federal government deficits increased in late 1979 and early 1980, placing further upward pressure on rates.
When looking at the historical parallels comparing the era of Vietnam and Great Society to the modern era of the Iraq and Health Care Debates, it's tempting to conclude that double-digit inflation will be knocking at our door. Before falling for this intellectual trap, we need to understand that our economy today resembles the deflationary era of the 1930?s Great Depression more than the inflationary era of the 1960s. Let's not fall into the trap of forecasting inflation anytime in the short term. For the near term, remember that Japan had low-interest rates for 15 years, rising oil prices and unsustainable budget deficits, but they experienced 20-years of deflation and not inflation. For the long term, we can forecast inflationary pressures as a result of fiscal deficits and the depreciation of the dollar.
The Present Danger Of Deflation
"There is the possibility … that after the rate of interest has fallen to a certain level, liquidity preference is virtually absolute in the sense that almost everyone prefers cash to holding a debt at so low a rate of interest. In this event, the monetary authority would have lost effective control." - John Maynard Keynes, The General Theory
"Indeed, there is an especially pernicious, albeit remote, scenario in which inflation turns negative against a backdrop of weak aggregate demand, engendering a corrosive deflationary spiral." - Alan Greenspan, 2003
"It is also interesting to see how government bond markets are reacting to the oil price surge -- by rallying, not selling off. In other words, bond market investors are treating this latest series of events overseas as a deflationary shock." - David Rosenberg, 2011
Economists define inflation as "too much money chasing too few goods and services." You'll notice that there are three parts to this definition being the "too much money" part, the "chasing" part, and the "too few goods and services" part. We know that governments through quantitative easing have created "too much money." However, consumers are not "chasing" goods and services because of unemployment, under-utilized factories, fear and uncertainty, bankruptcies, over-indebtedness, stock and real estate asset depreciation, and higher levels of frugal retirees. Without consumer spending, prices and wages fall and economic growth declines. In addition, because of the low costs of global labor, the global economy (especially China) created excess capacity by overproducing their products and overbuilding their factories. What happens when you have "too much money," "too little consumption," and "too many goods and services"? Near-term deflation and long-term inflation.
In Bernanke's 2002 speech about deflation, he states that the Fed could put a ceiling on interest rates by having the ability to make unlimited purchases of securities that are two years from maturity. He also argues that the Fed could offer zero percent loans to banks based on restricted asset classes (including auto loans, commercial paper, bank loans, mortgages, and corporate bonds) for collateral. Bernanke's speech became known as the "Bernanke put" and many bond investors believe that they can buy bonds without fear of value declines because the Fed would step in and buy bonds to keep interest rates low.
For over a decade, the world experienced deflationary pressures caused by $4/day labor. This fact was deeply hidden by the booming asset bubbles in the real estate and stock markets. When the stock market crashed in 2008, we saw a sharp drop in prices (as seen in the graph on my blog at http://zempower.com/archives/713), which explains why the Fed started QE1 (November 2008 to March 2010) and QE2 (November 2010 to March 2011).
Source: Bureau of Labor Statistics
QE1 and QE2 seemly accomplished the target of devaluing the dollar and causing oil and commodity prices to rise. Although gas prices rose by 4.7% in February 2011, according to the U.S. Bureau of Labor Statistics the Consumer Price Index for All Urban Consumers (CPI-U) increased only 0.5% on a seasonally adjusted basis. Interestingly, recent data shows that commodity price increases have not been passed by businesses to their customers. With Fridays reporting showing unemployment levels at 8.9% and the Thomson Reuters/University of Michigan consumer sentiment index dropping to 68.2 in early March from the end-February reading of 77.5, businesses seem reluctant to increase their prices while raw material prices continue to rise.
The upward trend in the consumer price index makes it sound compelling that the deflation threat has passed, but don't forget that quantitative easing added $2.1 trillion to the economy. What happens now that QE2 has officially ended?
The economic indicators that point to slow GDP growth and deflation include 1) data showing high levels for inventory liquidations accounting for 60% percent of real GDP growth in the five quarters through the third quarter of 2010; 2) excessive inventories in the housing market; 3) falling state and local government spending and payrolls; and 4) a net fiscal stimuli that is decreasing by $100 billion. In addition, events that could trigger a market crash that would cause deflation include 1) the sovereign debt crisis in Europe; 2) a correction in the commodities market; 3) correction in the China boom leading to Chinese bank failures; 4) a correction to the current account deficit; and 5) a global recession caused by slumps in export-driven nations as a result of dollar depreciation.
Long-Term Inflation Threat
It's not difficult to surmise that the Federal government's fiscal deficits and the Fed's quantitative easing will lead to long-term inflation. When central banks, hedge funds, private equity funds, and sovereign wealth funds take flight from the dollar, the exchange rate depreciation will cause food, oil and other commodity prices to rise.
Similar to the 1960s where we saw both militarism leading to the Vietnam War and liberalism in Lyndon B. Johnson's Great Society, the fiscal failures of the US government caused by militarism and liberalism in the last 10 years resembles the 1960s. In the "great inflation" of the 1970s, poor fiscal policy on the part of government led to escalating interest rates and a reluctance from capital investors to commit funds to infrastructure development. For example, three month treasury bill yields averaged 5 percent in 1976, 5.3 percent in 1977, and 7.2 percent in 1978. By June 1979, the yield was 9.1 percent but, by early April 1980, it had jumped to 14.8 percent. Federal government deficits increased in late 1979 and early 1980, placing further upward pressure on rates.
When looking at the historical parallels comparing the era of Vietnam and Great Society to the modern era of the Iraq and Health Care Debates, it's tempting to conclude that double-digit inflation will be knocking at our door. Before falling for this intellectual trap, we need to understand that our economy today resembles the deflationary era of the 1930?s Great Depression more than the inflationary era of the 1960s. Let's not fall into the trap of forecasting inflation anytime in the short term. For the near term, remember that Japan had low-interest rates for 15 years, rising oil prices and unsustainable budget deficits, but they experienced 20-years of deflation and not inflation. For the long term, we can forecast inflationary pressures as a result of fiscal deficits and the depreciation of the dollar.
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