Can Deflation Be Avoided? 27 comments
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Here’s what Nouriel Rubini says about deflation:
Deflation is dangerous as it leads to a liquidity trap: nominal policy rates cannot fall below zero, so monetary policy becomes ineffective. Falling prices mean that the real cost of capital is high and the real value of nominal debts rise, leading to further declines in consumption and investment - and thus setting in motion a vicious circle in which incomes and jobs are squeezed further, aggravating the fall in demand and prices.
The simple way I like to think of deflation is that falling prices keep people from spending money unless absolutely necessary because they become confident that they can get more for their money later. This leads to the perfectly rational notion that holding cash is good. The perception of the high value of cash leads to a vicious circle of lower revenues and lower prices. The same principle holds for investments; cash becomes a rational alternative to stocks and to any bonds that are perceived to entail risks.
Rubini was the most negative economist going into the current downturn, which makes him the most correct. A full commentary on his expectations going forward is here. In sum, he expects a horrible economy in 2009 with a risk of deflation but with the possibility that aggressive government actions taken around the world could save us from that.
I suppose the best indication of whether the world will fall into deflation or not will be the action of the stock market. If it tanks below its November 20th lows and keeps heading south then it probably is signaling a multi-year period of deflation during which one does want to be in cash.
If it can stay above those lows (which are about 15% below the current market levels) and perhaps work higher, and the longer it does that, then it is signaling that the worst has been seen. If that is the case then in general one would want to go back into the water. I suppose the best stocks to own will be those good companies that have been hurt the most. An example, and one that I own, is TBSI, a shipping company with a unique high-service-component profile that is less impacted by the Baltic Dry Index than are bulk carriers.
Obviously there are many other beaten down stocks, not least Citibank (C) and other banks. I expect that reforms to the regulatory system and simple market damage will vastly erode the “shadow banking” alternatives to real, government- regulated and deposit-guaranteed banks. So the banking business should be pretty good in the next upturn.
Will oil stocks be among those that react best on the upside if the economy has bottomed? Perhaps so. But a substantial glut in spare oil capacity is building, particularly with the more optimistic outlook for Iraq. So I suspect the price of oil itself will not obtain $100 plus levels for some years after the economy bottoms. Thus oil stocks will begin to discount somewhat higher oil prices quickly. But I doubt the bounce in oil stocks will be quite as robust as the bounce in stocks of companies that are more sensitive to an economic recovery.
The question is whether the next upturn will come before a fall into deflation occurs. In addition to watching stock prices to get an early reading on that question, I will continue to scan the data environment in the hope of finding some signals that might be useful. Feel free to contribute your own observations on the deflation outlook, dear readers. And Happy New Year.
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This article has 27 comments:
Deflation...you kidding...were already into a DEPRESSION that I suppose could last a few years. Its hard to pump up the economy without job restoration/growth and this is what we should all be looking for...work work work either by private or government sectors...Obama promise of jobs will help but its going to be a long time coming before we see any results on the economic numbers. Also markets have been distorted by government interventions in major industries and we do not have a new economic model of how this will work out so any projections about timeing will be just a rats ass guess...MarvinMBA
Jim, your quote- The question is whether the next upturn will come before a fall into deflation occurs.
Don't you think deflation has already occured, in spades? Housing, energy, commodities, stocks, interest rates, personal wealth, company wealth- what hasn't deflated? I mean, what are we looking for, beyond what has already occured? I would assume a continuation of these trends- housing not bottoming, oil plateauing or even down more, etc; Baltic Dry Index remaining flatlined?
On Dec 31 03:28 PM patio wrote:
> First of all, Happy New Year. That phrase actually has true meaning
> nowadays.
> Jim, your quote- The question is whether the next upturn will come
> before a fall into deflation occurs.
> Don't you think deflation has already occured, in spades? Housing,
> energy, commodities, stocks, interest rates, personal wealth, company
> wealth- what hasn't deflated? I mean, what are we looking for, beyond
> what has already occured? I would assume a continuation of these
> trends- housing not bottoming, oil plateauing or even down more,
> etc; Baltic Dry Index remaining flatlined?
jepittman, you quote gub'ment stats, puh-lease!
On Dec 31 03:59 PM dcb wrote:
> the idea that we will see a significant period of deflation is plain
> wrong. We aren't japan with as big a bubble to burst, and whenever
> everyone is talking bout something means it ain't going to happen.
> Remember 200$ oil. Our government is doing everything it can to allow
> banks and industry to lever up again (getting us ready to the same
> thing to happen again once more). The worry is going to be if anyone
> will turn off the money flood before we get to the 70's again. The
> market like to push things to extreme before it turns and knows that
> by doing so it can manipulate washington through fear. Remember these
> are the guys who believed speculators had nothing to do with pushing
> oil to 147$. My vote is for stagflation and a ruined currency.
When the market has given back the gains it harvested from the housing bubble, then the housing recession will come to an end. IMHO we are there are near there. I would propose that market asset decay beyond that could signal the beginning of deflation. Again, imho, what we've seen so far is Recession, S&P below 750 will be Deflation.
However, they cannot print hydrocarbons, which is why oil rallied strongly today.
I suspect that oil will burst through this year's high as soon as reflation appears likely to succed.
Jim, I've enjoyed your articles. Happy new year to you and to all on this forum.
Rite!
Raise prices!
The rents!
Houses!
Food!
Drugs!
Energy!
Clothes!
Education!
THAT WILL FIX EVERYTHING !!!!!!!!!!!!!!!!!!!!!!...
Of course !!!
PPL will start to buy again...
...because if they don't...
prices will go even higher!
It's psychological !!!
So Simple! Dontcha Get It!??
www.youtube.com/watch?...
WAR IS PEACE!
FREEDOM IS SLAVERY!
IGNORANCE IS STRENGTH!
away the leverage and what do you really have? Go to the charts, look where
the bubbles started and we have to at least include the "possibility" of a long
painful re-track. Certainly 10+ years is a possibilty.
The horrible side because of this is much higher costs of living during this span.
So stagflation or low growth could be here for years. Real estate is likely dead
in the water without 100% financing and foreign purchases...commercial re markets ditto...2nd home market ditto...retail ditto...services ditto..etc.
We have a major structural problem with industry and China trade..
Wages are headed south ...time to work for the government..
every action has a reaction...no 700k mortgages for fruit picker wages!
the problem with the market rising is the remaining shoes which have not fallen - specifically commercial real estate. i try to continually separate in my mind economic conditions, market conditions, and business conditions. although they are inter-related, they all have their own forces to drive them.
the market will be constrained by falling revenue effecting p/e's for the next three quarters minimum. it would be best if the market just hovered (neither up or down) to build investor confidence through this crisis. the last thing anyone should want is the market to take of in anticipation of economic recovery, and be kicked in the stomach with earning realities.
You know, we've had real inflation since the housing bubble really took off. But, we've been able to hide it from cheap imports from China (Ron Paul, congressional hearing Oct 07...as he berated Bernanke.) Of course, minus food and energy, those don't come from China. And China has imported much of our inflation.
Now, with the credit markets stalled, money velocity is down. FOlks are spending less (not creating much debt money.) Along with deleveraging, the money supply is falling, too, by whatever means you measure it...zero maturity money or otherwise.
Ironically, it seems we are seeing deflation in asset (AIG sold off it's boiler insurance asset at a pretty huge loss) and commodity prices, but not so much from consumer non durables or food. And with the dollar making up the lion's share of global liquidity (along with the now defunct yen carry), well...they are becoming more scarce. So, is the euro and the sterling, just proportionately at differing rates and amounts.
So, yes, I guess once could argue we have entered a deflationary period. And with much deleveraging still to go resulting from the inflationary driven leveraging of the past decade (actually, since the 80's), this might turn out to be quite a lengthy process.
I assert we're at the end of our fractional banking business cycle. We're top heavy with debt at 350% of GDP. The fractional banking system must correct, it seems unable to support this much debt top heaviness. Just a theory. I doubt debt can be infinite, so it seems it must correct to much lower levels before it can sustain further money creating in the form of new debt.
So, debt is disappearing...hence money is disappearing. And I have asserted it is disappearing faster then the Fed can replace it. It took a decade or longer to grow and only a few months, and maybe more to come, to vanish. So, deflation appears to be real.
Now, we do stand on a dam that really wants to break. With interest rates effectively at zero, the wheels are greased to create huge money velocity. Along with huge, cosmic scale, bank reserves, a lot of water sits behind that dam. And a burst dam certainly means an end to deflation. And by end of deflation, I mean hyperinflation. The threat is very real. But, I do not expect this damn to burst until toxic debt is freed from bank books.
So, again...and as the author implies, it's all in the timing. How long will deflation be with us? And how will be be restructured afterward? I suspect, as the author does, we will have regulatory changes and actual oversight in the creation of new money. I suspect the Fed will regain control over the money supply, which is currently many times the volume of Fed power money. (10 times the fed power money, thereabouts. I mean, we are talking world liquidity here.)
Financial instruments once considered safe enough to allow 30 times their value to be added to bank credits will no longer be so lucrative, i suspect. I further suspect the Fed will be as aggressive fighting inflation as they were in stoking it. And I imagine they will be just as creative in controlling it.
Sorry, for the long reply...
A comment relating to the comment stream:
To sort out the points all are trying to make, we need to recognize that there are several different flavors of inflation and deflation mentioned. Now Inflation has been high for the past several years; The highest inflation has not been in many of the items measured in the CPI. It has been in financial paper, houses, industrial commodities and stocks (although stocks did deflate 2001-2002). Now the CPI has come down but the real deflation has been occurring in the things that were hyper-inflated (into a bubble). jepittman commented on the CPI, and that does have significant impact on living expenses, but the deflation is in things related to wealth. The wealth destruction for the average American has been catastrophic, much more damaging than the cost of living. The home is the biggest reservoir of wealth for the average American and retirement savings a close second. Both of these are down 25-50%. A drop in the CPI, which will probably be temporary (barring a depression), will do little to assuage the negative wealth effect.
Happy New Year to all. I wish that you all may have a better 2009 than 2008.
There appears to be something wrong with the "here" link to Rubini. I reached a sign-up page for gmail.
Currently we are in some kind of stock rally but if sp500 tops out around 1000 level, maybe time to short or sell out.
On Jan 01 12:21 PM AlexR wrote:
> If there is severe deflation in rich countries, what would keep emerging
> markets, which historically have no qualms about printing money,
> from buying up the world?
On the actual matter, I think John Lounsbury's point clarifies my own view of inflation and deflation and I should have been more clear and specific. Leading up to late 2007 we experienced conflicting trends of inflation and price declines. There was an asset inflation of enormous proportions in houses and stocks that lasted for many years. There was also some inflation in commodity prices based on real demand from the growth of the world economy. At the same time we experienced price reductions effectively in imports and real wages in the U.S. based on globalization. So any discussion of past or future "inflation" or "deflation" needs careful definitions which I did not provide because different parts of the economy can experience rising and falling prices simultaneously.
When I used the word "deflation" I was thinking about the term as defined by economist to refer to CPI, which, as has been pointed out, is still in positive territory. I'm not an expert on the CPI, but I'll accept it at face value for now. It seems to me as a general rule that if CPI turns negative for long enough the economy can be said to be in a period of deflation. I think that's what Rubini means and his caution about liquidity traps, etc. refers to that.
Clearly we can avoid such deflation while still experiencing the unwinding of the asset bubbles that created enormous increases in the prices of homes, stocks, and (though caused not by a bubble) commodities. The dangerous risk is not the fall in asset prices but a much more general fall in CPI that produces a self-reinforcing feedback loop that it is very hard for government to reverse and which basically emasculates the Federal Reserve because of the "pushing on a string" problem.
also, i don't so much think deflation is coming, as that it's here, but just beginning to be really barely felt
just my thoughts :-) eventually, we'll see....
I realize I am picking nits here but if we are discussing deflation we need to have a consistent definition for what it is.
Finally, Mr. Patio obviously distrusts anything emanation from a "gub'mint" source. It would be interesting to know whose statistics he believes.
On Jan 01 12:36 AM John Lounsbury wrote:
> Jim Kingsdale - - - Good article, consise and to the point.
>
> A comment relating to the comment stream:
>
> To sort out the points all are trying to make, we need to recognize
> that there are several different flavors of inflation and deflation
> mentioned. Now Inflation has been high for the past several years;
> The highest inflation has not been in many of the items measured
> in the CPI. It has been in financial paper, houses, industrial commodities
> and stocks (although stocks did deflate 2001-2002). Now the CPI has
> come down but the real deflation has been occurring in the things
> that were hyper-inflated (into a bubble). jepittman commented on
> the CPI, and that does have significant impact on living expenses,
> but the deflation is in things related to wealth. The wealth destruction
> for the average American has been catastrophic, much more damaging
> than the cost of living. The home is the biggest reservoir of wealth
> for the average American and retirement savings a close second. Both
> of these are down 25-50%. A drop in the CPI, which will probably
> be temporary (barring a depression), will do little to assuage the
> negative wealth effect.
>
> Happy New Year to all. I wish that you all may have a better 2009
> than 2008.
Currently, there is NOT the means for the rest of the world to compete robustly with us for our own goods and services.
Robust world competition for our own goods and services has happened for considerable lengths of time in the past as in the entire 1970's ,and part of 80's(see below),and we got a taste of it in 2007 with the commodities bubble , but it was short lived because of systematic wealth destruction quickly overwhelming it..
The 1970's, 80's inflation period was caused by the huge pools of money injected into the world economy by an expensive and protracted Viet Nam war. Added to the war,later in the 80's, was the money center banks making huge (unwise) greed based unsupported profligate loans to So. America and developing countries to reap the high interest rates available to them. This led to the banking crisis of that period when they (So. Amer.) were not able to repay the loans on schedule, and even then American intervention was required to forestall a meltdown, which later was admitted freely and entirely by Treas. Sec. Regan, who said "We almost lost it all."
This money came back to America as high demand for our own products which had the effect of increasing the money supply and making goods less available at a fair price to the domestic population because the products were being "shipped out". Hence, high and rampant and protracted domestic Inflation. An additional factor , was Corporate punishment of the Carter Admin. for daring to challenge them on many fronts, including the boycott of the Russian Olympics, and unwarranted price gouging ,and since inflation had started in the Nixon/ Ford admins , it was easy to throw fuel on the fire that was already underway and sieze quick and easy profits with the Carter admin. taking the blame (worked like a charm), and the Corporate media solidified it with relish so it had to be right..
We may be in store for something like this again later, but NOT now.
In addition, there is not the domestic robustness, or confidence ,or incomes for we ourselves to demand and consume our own goods and services beyond a sustenance level at the current time.
When high school and college seniors can look forward to a good entry level job waiting for them again, when unemployment is driven down to frictional levels again, when massive layoffs stop, and when some confidence is restored in our economic and political systems, when entreprenuership, imagination, optimism, vision, and risk taking reassert themselves again, etc. ,a return to reasonable equilibrium has a chance to unfold with no serious inflation or deflation, i.e. relative price stability.
This means get ready for a continuing period of DEFLATION in the "near term."
After that , what happens depends on the skill and will of the people and their chosen leaders combined with world events, and their interactions, and nothing pro or con, can be ruled out. Since inflation has occurred often and periodically in history, and counter deflation strategies are intensifying daily, one can never let their guard down relative to inflation, even in a deflation like this one.
All the history is just off the top of my head, but I believe it to be valid and accurate.
Nothing has changed. Deflation and deleveraging are still the Trend Setters. The main spill over is yet to come: Commercial, Retail, State Defaults(at least rumors of same), total elimination of many small banks and insurance companies and the Bankruptcy of at least one Major Homebuilder. I can expand the list, but the prior will do for now.
This Secular Bear Market started with the Internet Bubble, The Fed stopped that decline by allowing the Housing Bubble, followed by the Financial Bubble.
All have now burst. Bubbles Take years to resolve because it takes years to restore the Public's confidence.
You can "fix" some things with elaborate stimulus packages but Investor Confidence? The Money on the sidelines will stay on the sidelines. Debt expansion has been replaced by Debt reduction. Credit Card Usage is dropping in part because of stricter guidelines but more importantly because Credit Card Issuers are raising rates on outstanding balances instead of reflecting the current rate environment.
It is my belief that only one thing can stem the expectation that prices will continue to drop. An inflationary shock which would encompass everything manufactured and grown. Something which will guarantee that what you buy now will be more expensive later if you do not buy Now.
A quick rise in the price of oil is needed. My opinion, right or wrong.
On Dec 31 09:10 PM The hand wrote:
> Jim, nice post and happy new year.
>
> the problem with the market rising is the remaining shoes which have
> not fallen - specifically commercial real estate. i try to continually
> separate in my mind economic conditions, market conditions, and business
> conditions. although they are inter-related, they all have their
> own forces to drive them.
>
> the market will be constrained by falling revenue effecting p/e's
> for the next three quarters minimum. it would be best if the market
> just hovered (neither up or down) to build investor confidence through
> this crisis. the last thing anyone should want is the market to
> take of in anticipation of economic recovery, and be kicked in the
> stomach with earning realities.
>
Someone misunderstood my point about stocks and deflation. I did not mean that risings stock prices would cause the economy not to go into deflation (although rising stock prices would help improve consumer spending). What I meant is that rising stock prices would be a predictor that the economy is not falling into deflation.
A problem with my suggestion that we might use stock prices to predict deflation (or anything else) is what period to look at. For example, stock prices could well rise for a few months then fall back again so that the temporary rise would be only a correction in a bear market. Do you look at the rising period or the longer term trend?
It might take so much time for a true bullish trend in stock prices to emerge (a series of higher highs and higher lows that conclusively breaks the downtrend line) that by then it might also be clear from the rear view mirror that deflation was not prevailing.