The Battle of the 'Flations

One of the most hotly debated topics among financial talking heads these days is, “Deflation or inflation, what is it going to be?”

There is no question that we are currently experiencing asset price deflation and economic slowing. But we (the editors of The Casey Report) see this as a transitional phase. In our analysis, the truly extraordinary and historic levels of government spending and bailouts being deployed to keep the economy afloat are certain to lead to inflation in the not-too-distant future.

While our long-term view remains solidly in the inflation camp, over the past four months the U.S.’s financial problems have caused deflation in many important asset classes. Put another way, a reduction in asset prices amounting to about $14 trillion (in housing, equities, etc.) is bigger than the government’s countervailing actions of around $3 trillion -- the total, so far, arrived at by combining the measures taken by the Fed with the federal government bailouts.

But there are important differences between a sharp collapse in asset prices and the potentially leveraged stimulus packages.

The Fed’s actions, if taken in normal times, would be multiplied throughout the banking system as banks used the new money to increase their lending and, in so doing, leveraged the funds throughout the entire economy. This time around, however, while the Fed has been extremely accommodating to the banks, even going so far as to make direct loans to them, the effect is moderated. That’s because of tighter lending standards, the need to replenish capital, and the demise of many complex structures, which were previously available for securitizing and selling loans on to others.

As a result, the banking system as a whole is not responding to the stimulus. It can be thought of as pushing on a string. Simply, as large as the stimulus has been to date, it has not yet been enough to offset the effects of the economic collapse. The resulting deflationary pressure increases concern over a downward spiral in the economy.

Another way to view this is that consumers and businesses alike are now anticipating deflation, which makes saving and survival the primary goal. (In an inflation, spending becomes the primary goal, unloading the money before it can lose value.) Of course, a cutback in spending and demand drives down the price of things, at least temporarily.

But the longer-term expectation is that Bernanke’s assertion – an assertion now backed up by action – that the government can and will print new money to any extent needed is the more important force.

As long as there is evidence of serious economic collapse, it can be expected that the bailout programs will be ratcheted up. And, to the extent that the public expects deflation – and so businesses reduce prices to raise cash and reduce inventories – the wave of price inflation experienced in the spring of 2008 will be moderated. But within the seeds of that positive are the very big negatives that the government, seeing that its extraordinary money creation is not being evidenced in rising prices, will be emboldened to go even further.

This is of great importance because, unlike in the 1930s, there is no limitation on what the government can do because there is no gold standard to enforce monetary discipline. Instead, the world is afloat on a sea of massive new government spending and credit facilities. After a lag, the stimulus will perform the expected actions of reinstating credit and debasing the currency. But never lose sight of the fact that the government is creating money out of thin air. Some call it bailouts, we would call it legal counterfeiting on an epic scale.

In the New Deal, FDR created the FDIC and guaranteed bank deposits, set minimum bank deposit rates, and brought the discount rate to almost 0%. He cut the dollar/gold exchange rate from $20.67 to $35 and confiscated gold; i.e., devalued the dollar by 40%.

While the beginning of the collapse from too much credit was parallel to the previous experience of the depression, the response today is different. The size of the monetary stimulus and the risk to the dollar from foreign holders -- who can also see the implications of the out-of-control deficits -- strongly argue for a return to inflation much sooner.

How much sooner? Impossible to say, but remember: deflationary or inflationary fears are not the independent agent that will determine whether or not we will see inflation (though, in the intervening phase, they will certainly be an important economic driver). The Federal Reserve is throwing everything it can at the financial markets to fight deflation. As you can see in the chart below, the Fed has doubled the size of its balance sheet since September.

On December 16, the Fed cut interest rates to a range of between a quarter of a point and zero. That is lower than ever in the 94 years of their existence. And they promised in the accompanying announcement to provide additional funds to “stimulate the economy through open market operations and other measures that sustain the size of the Federal Reserve's balance sheet at a high level… the Federal Reserve will purchase large quantities of agency debt and mortgage-backed securities to provide support to the mortgage and housing markets.”

At this time, individuals and companies alike are sensing deflation and, as a result, are raising cash… in the process deleveraging the extreme debt loads. That is causing downward pressure on asset prices and, soon, a serious contraction in the economy as more and more companies lay off workers and cancel spending. This will not be a happy holiday season. And it will be a long-term recession and maybe even a protracted depression.

But the fact of the extraordinary deficit spending is there for all to see and, over time, more and more will see it, and more to the point, they will understand it. In fact, thanks to the Internet and always-there financial media, the shift in sentiment can happen almost on a dime. Slowly at first, and then faster, fears over inflation will return, but this time they will be well founded.

The economic downturn could be protracted, but that does not mean that the deflation will be protracted. Instead, once we are through this phase, we expect to see poor economic conditions, but against a backdrop of rising inflation. Stagflation is a word that remains in our vocabulary.

Inflation or deflation – whatever the current market trend, there is a way to play it. Every crisis contains opportunity as well as danger… and many of those who manage to mitigate the risk and grab the opportunity have made a fortune in times like these.

Making the trend your friend and riding the market “riptides” that can lead to exceptional returns in the double, triple or even quadruple digits is easier than you think… with a little help from experts who have been correctly predicting – and profiting from -- these riptides for years.

Comments

[patio:]

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Fuq off.

2008 Dec 19 09:57 AM

[gabe borens...:]

Deflation was an issue for quite some time and it will be an issue in the period to come.It is being addressed aggressively .We just need to make sure that any weak structural economic link is addressed without delay -political/economic criticism can wait.
At this juncture the implemented measures need time to have the anticipated impact(lag).
It is the negative psychology that appears to distort the fundamentals.
Clearly U.S economy is bottoming out(unemployment data is unnerving but it is a lagging economic indicator),but Asia ,Europe Emerging markets are yet to feel the massive "economic "pain.
The global economic recovery cycle is driven by the U.S period.
It had taken almost a year for the global economies to comprehend the magnitude of the economic issues and most countries are still lagging in dynamic response necessary to abort dire consequences.
I expect a massive capital inflows into U.S to continue and eventually contribute to a dynamic recovery in the period ahead .
By the end of the first qtr of 2009 U.S economic stability will have arrived .By the second have of 2009 ,explosive economic recovery will be on the way.
I am sure that the peanut gallery will respond with some criticism....but ...
I have predicted the current events as early as June of 2005 in an interview with Mark Gilbert(Bloomberg London).and predicted the yields on the 10 yr treasures will implode to 2.5% .
On September 18 ,2007 during the FED time I was interviewed by Brian Sullivan(Bloomberg TV) and I have reiterated the Armagedden scenario that was about to hit the U.Seconomy.
Now ,I am taking the other side of the consensus ....but i do believe that the SEC should impose moratorium on the short sales (stocks) immiediately to allow the implemented measures to work.

2008 Dec 19 10:56 AM

[JasonC:]

Never lose sight of the fact that the braintrust telling you the Fed is stupid just lost $20 trillion betting on a hyperinflation that isn't happening, while the Fed correctly saw coming the deflation that is happening.

The Fed isn't stupid. But a lot of traders fighting it are stone cold morons.

2008 Dec 19 11:01 AM

[Malkiel:]

leveraged private credit is the same thing in the private sector as "printing money" is for the public sector, minus the picaresque and pejorative imagery. It's only okay to get hot under the collar about the government "printing money" if you're also upset about investment banks inventing credit default swap instruments in order to fabricate collateral for leveraged borrowing...

2008 Dec 19 11:04 AM

[Larry House:]

Just a long advertisement. You should be paying to post such as this. Not helpful at all.

2008 Dec 19 11:15 AM

[axelrod608:]

Asset deflation as the rising tide of foreclosures won't start receeding until 2013 and the $1.3 quadrillion in derivatives globally turns sour. Inflation of commodities once the fuel correction ends. So, both. Be cautious where your money is.

2008 Dec 19 11:27 AM

[Byron_G:]

"You jump out of the Nikkei market at the end of 1989 (just before the market collapses)"

riiiight....please stop posting these crap articlevertisements on seekingalpha.

2008 Dec 19 11:32 AM

[timhope:]

Although you could argue that the Fed was asleep at the switch for the last decade, you have to give them credit for recognizing the severity of the situation rather quickly. And the Fed is not stupid - they are trying to avoid a deflationary spiral by pumping as much money into the economy as necessary. Bernanke and company are quite openly trying to stoke inflation as they feel its the lesser of two evils. A debased US dollar is essentially the only plausible way to pay down all our debts without defaulting. The question is can they succeed without tipping too far the other way towards hyperinflation. As a side note, I have read a number of Bud Conrad's posts and have generally enjoyed them. Although the blatant plug at the end is really unprofessional.

2008 Dec 19 11:40 AM

[jeandit75:]

these promoting aarticles should not be allowed

2008 Dec 19 03:12 PM

[kurtieboy:]

There's gold in them there hills!!!!

2008 Dec 19 06:09 PM

[sickofthehype:]

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2008 Dec 19 07:31 PM

[Asbytec:]

Yea, seems the top down bailout just isn't working. I don't like to refer it to pushing on a string, but more like trying to kick down a steel door.

Man, I wish we could have implemented a bottom up bail out so Joe the Plumbers of the world could have money to pull on that string...to open the steel door from the inside.

Had we saved home mortgages in a viable way, housing prices might have stabilized by now. And this isn't hind sight, it's blind luck. I argued for a bottom up bail out for different reasons...to save the little guy because it was the right thing to do.

So, is the targeted deflation we are seeing a demand driven price change or a real monetary deflation?

2008 Dec 19 10:38 PM

[Jeff Nichols:]

Gold as a deflation hedge:

During periods of deflation, we postpone spending in anticipation of lower prices. Instead, households hoard cash and cash-equivalents such as short-term U.S. Treasury debt, bank deposits, and money-market instruments. Gold is also a cash-equivalent . . . and some will choose to hold more of their savings in the yellow metal, particularly during times of economic stress and uncertainty when gold just feels safer.

Moreover, deflations are also characterized by very low interest rates. Rates are low because the demand for credit is depressed, savings are high, and the Federal Reserve and other central banks will pursue low reflationary interest-rate policies to encourage economic recovery.

As a result, the opportunity cost of holding gold – that is, the income forgone by holding these metals rather than interest-bearing assets – is also extremely low, further encouraging some investors to favor the precious metal over alternatives because of its other attractions and attributes.

For more on gold, deflation, inflation and the economic outlook, see my blog, NicholsOnGold.com

2008 Dec 20 10:31 AM

[John Lounsbury:]

gabe borenstein - - -

Thanks for sharing your thoughts. I'm afraid I do not share your optimism for 2009.

There is one specific I would like to debate:

You wrote: "(unemployment data is unnerving but it is a lagging economic indicator)."

This is a commonly quoted adage, but the reality is not that simple. Employment is a lagging indicator, a coincident indicator and a leading indicator, depending on the statistic examined.

There are two labor statistics in in the Index of Leading Economic indicators:
1. Average weekly hours of production workers (manufacturing)
2. Average weekly initial claims for unemployment insurance (inverted)

There are two labor statistics in the Index of Coincident Economic Indicators:
1. Employees on nonagricultural payrolls
2. Personal income minus transfer payments

There are three labor related statistics in the Index of Lagging Economic Indicators:
1. Average duration of unemployment (inverted)
2. Change in index of labor cost per unit of output
3. Ratio of consumer installment credit outstanding to personal income

These indexes are maintained by the U.S. Department of Commerce:
bea.gov

The two leading indicators are still pointing down.

2008 Dec 20 11:23 AM

[John Lounsbury:]

The link is bea.gov

2008 Dec 20 11:25 AM