Bizarre Barron's Article On Deflation

by: Acting Man

Falling Asset Prices Are Not Deflation

We always stress that the great financial crisis has indeed left the economy with what one might term a "deflationary undertow." To the extent that households try to deleverage and are paying back debt and to the extent that banks refuse to expand credit concurrently, there is a theoretical possibility that the money supply might one day decline. It must also be stressed that this is highly hypothetical at this stage, as it has simply not happened yet.

On the contrary, the Fed has actively pumped up the money supply at a truly astonishing pace. See for yourself:

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Broad U.S. money supply TMS-2 – there's no deflation in sight so far – via Michael Pollaro – click for better resolution.

Moreover, falling prices as such are not evidence of deflation, including falling asset prices. This is however what Barron's asserts in a recent article, whose author muses over whether the 'Fed is losing the fight against deflation'. Say what? According to Barron's:

Ben Bernanke seems to be losing his battle with deflation, observes Walter J. Zimmerman, chief technical analyst for United-ICAP. So far, the Fed's scheme announced in September to buy $40 billion of mortgage-backed securities for however long it takes to lower unemployment has little to show for it. Quite to the contrary, market prices show the U.S. central bank has shown itself impotent in its fight against the undertow of deflation.

Global stocks and commodities are down significantly from their peaks reached in mid-September while the dollar has strengthened, he points out. That is contrary to the record of QE1 in 2009, QE2 in 2010 and so-called Operation Twist (the Fed's purchase of long-term Treasuries and offsetting sales of shorter-dated maturities) beginning in 2011. While the first two iterations of QE boosted stock and commodity prices and lowered the dollar significantly from their outset, the markets have done the opposite under QE3.

Zimmerman writes the Standard & Poor's 500 rose some 63%, or 5.3% per month, following QE1. After QE2, the S&P 500's cumulative gain was 9.7% or 1.4% per month. Operation Twist produced a 30% gain, or 2.7% per month. In the two months since QE3, the S&P 500 was off 6.9% as of Friday.

All that the above observations show is that monetary pumping is less and less effective in terms of lifting already elevated asset prices and increase the overvaluation of such assets even more than it already has (leaving aside that prices already rose ahead of the QE3 announcement). If the Fed wanted to achieve that, it would probably have to engage in accelerated money supply inflation. The same rate as before cannot do the trick so easily: it doesn't have the same effect as the first iterations of QE, due to today's higher prices and the fact that a lot of scarce capital has been misallocated over the past few years as a result of the inflationary policy enacted to date.

As a rule of thumb it can be stated that the more the economy is weakened structurally through inflationary policy, the fewer resources remain that can be diverted into new bubble activities. This too is a reason why the newest inflationary program is not affecting asset prices to the same degree as before. So yes, stock prices may well decline. One cannot tell beforehand where the newly created money is going to go, stocks are not a guaranteed beneficiary. However, as long as the money supply grows – and it continues to grow at a brisk pace – there is no deflation. There was no deflation when stocks and commodities crashed in 2008 either. At no point did the money supply decline, not even by a single cent.

The most recent data show that as of September, the broad money supply TMS-2 grew at 20.1 percent annualized during the month, and at a 10.1 percent annualized rate during the quarter. There have only been one or two months in the past four years when it has grown at less than 10% annualized. Of course deflation cannot be ruled out at some point in the future. The Fed may e.g. alter its policy – as unlikely as that appears to be, it is not totally impossible. It should also be borne in mind with regard to QE3 that the first major settlements are only expected to begin by mid November. This is to say, it has not yet shown up in the monetary base, but will do so soon.

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U.S. monetary base – as soon as the Fed's first QE3 MBS purchases begin to be settled, it should resume its growth trajectory – via Saint Louis Federal Reserve Research – click for better resolution.


There is nothing yet that suggests that Ben Bernanke is "losing the fight against deflation," mainly because there actually is no deflation he could possibly fight. Nowadays falling asset prices have a tendency to induce both fear of deflation and additional inflationary policy measures. If any evidence of actual deflation should become available, we will let you know.