Deflation: The 800-Lb. Gorilla in the Room 15 comments
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It's an old story, but it's getting worse, and so ignoring the 800-pound gorilla in the room is getting tougher by the month.
Deficits and debt are mounting, and changing the trend won't be easy. We can debate if the U.S. will muster the intestinal fortitude necessary to even slow the pace of red ink's ascent, much less reverse it. But in terms of absolute and relative levels of debt on the country's balance sheet, the future looks assured, as a growing chorus of observers warn.
That includes a fresh advisory from the St. Louis Fed. The title says it all: Deficits, Debt and Looming Disaster: Reform of Entitlement Programs May Be the Only Hope. "For the fiscal year 2008, the federal government’s deficit totaled $455 billion, the largest ever for a single year," Michael Pakko, an economist at the bank, writes. "In the final days of the fiscal year, which ended Sept. 30, the total federal debt rose above $10 trillion for the first time."
To put the numbers in perspective, a chart from the article is illuminating, albeit in a grim sort of way. As a percentage of GDP, federal debt is roughly at the depths reached in the 1980s, the last time that such fiscal worries were front and center. Given the incoming Obama administration's plans to spend, spend, spend, it's a safe bet that when all the budgetary dust clears, the debt troubles of 20 years ago will pale by comparison.
click to enlarge
Yes, there's a strong case for arguing that what this country needs (again) is a good $800 billion (stimulus) cigar. This writer and many others have warned frequently over the past several months that as troubling as a spending spree is at this point, the alternative — deflation — is worse. Unfortunately, the only way to prevent deflation at this point is to shovel money into the economy, as we've discussed. We'd prefer another choice, but engineering a different scenario required different policies in years past. Having let the fiscal burden grow, we're now between the rock and the hard place with the deflationary winds blowing directly in our collective faces. Simply put, this is no time to balance the budget.
Yes, we as a nation should have been focused on that goal in years past, when the economy was growing and deflation was nowhere in sight. Oh, well. That was then and this is now.
The deficit and debt troubles are old news, of course. Countless observers of the economic scene have long been warning of the challenges that will eventually come home to roost if we don't amend our spendthrift ways. A year ago, yours truly contributed to this genre of essays and penned an article more than a year ago by the name of "The $64 Trillion Question: Is the long-term budget outlook really a ticking time bomb — and does the Federal Government need a financial advisor?" A dark bit of reporting, to be sure, but revealing just the same.
The sad news is that the outlook has continued to worsen since the article was published, and more of the same is on tap for the foreseeable future.
The St. Louis Fed piece sums up the primary challenge in all of this by advising that "the long-term fiscal outlook for the U.S. requires serious attention. The retirement of the Baby Boom generation and a slowing rate of growth in the labor force will create a demographic time bomb in which entitlement growth threatens to swamp available resources."
You don't need an advanced degree in economics to recognize that the promised future liabilities of the U.S. look unsettling. Ultimately there are only so many fixes. One is cutting spending, which means pulling away the government's promises to some degree on, say, Medicare and Social Security. Good luck with that one.
Then there's the old standby of raising revenues with higher taxes. Ideally, that would be funded by a surge in economic growth. Otherwise, the task becomes more politically risky. Nonetheless, raising taxes looks a bit more likely, perhaps even inevitable, relative to the prospects for cutting services. Even so, it'll be a while before anyone's brave enough to talk up that idea, at least among the politicians running the show these days. Indeed, in the current climate, President-elect Obama is now the leading advocate for tax cuts, as Bloomberg News reports.
Another solution, if you can call it that, is to inflate our way out of the problem. As history suggests, that's the usual path, in part because it's subtle and politically easy. No one ever votes for higher inflation; it just sort of happens and — surprise, surprise — everyone's shocked.
As we write, that's just what we're doing. Big time. Spending is the only game in town. But it has consequences. It always does. Indeed, there are any number of implications for investors given the fiscal outlook. Economist David Hale discusses an obvious one in today's FT: "Precious metals could emerge as a hedge for investors suspicious of central banks and fearful that inflation will be the simplest solution to the challenge of global deleveraging."
The flip side of that advice is worrying about Treasuries. In a world where the printing presses are running flat out, and interest rates are at record lows, the future for Treasuries, which posted powerful rallies last year, looks shaky. No wonder, then, that Barron's advises to "Get Out Now," warning that Treasuries are in bubble territory.
Summing up, deflation first, followed by inflation. Details on timing to be determined. Next question.
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The question then becomes: Why isn't the market discounting the future inflation? I don't argue with your logic, but am puzzling over why we're not seeing a market response consistent with that scenario.
One possibility would be: in the short term, there is a real danger that the system can "break". That is, if you're afraid of bank failures and Madoffs, you hold Treasuries because even if your broker goes bust, your Treasuries (but not necessarily your money market fund or your cash) are protected. Another guess would be that the liquidating forces of the unwind are so massive as to dwarf investment buying of the "inflation later" theme.
2) The market will shed the broker/middleman market whom was overpaid while the producers saw weak profits. Someone else had a great post I read last night about 'headquarterization' model on Naked Capatalism that describes the U.S. and UK outsourcing/service model brilliantly. The U.S. will become a producer once again - if you think that is going to happen tomorrow, good luck.
3) I am not a big Obama fan but out of all the options tax cuts are the best option combined with fiscal stimulus to smaller business/entrepenuars. So I agree with the general direction of the Obama economic team, somewhat pleasantly surprised. Cautious optimism you could call it. As you mention Mr. Picerno, there are no perfect options at this point.
4) The current crop of corporate and government are still largely in place. Emerging leadership with less to work with in the future will be making some of the tougher choices. 3-4 years is the historical norm of leadership/labor migrations. That puts us into the 2012/2013 years before we see sustainable Bull market although there are many more technical indicators which also speak into this time frame of next Bull as well.
5) Will some of the reinflation work? Yes but who knows the side effects? Probably sky high commodity prices in energy and subsequent trickle down. That would makes sense consider government heavily taxes the energy market. Will it be the Japanese version, Weirmar lite? I don't think any of us can really even take an educated guess without seen the fiscal stimulus package first. End of Q1 between earnings and this package should be most telling. I do think this will be a strange shaped W with the 1st leg down complete, see a reinflation stage, smaller shedding of excesses in 2011/2012 and slow recovery. But plenty of opportunity for the astute.
Policy makers will make every effort to avert a deflationary spiral.
In addition to encouraging consumers and produces to defer purchases, deflation raises real interest rates thereby necessitating greater quantitative easing and fiscal stimulus.
Obviously, the potential outcome and aftermath gets pretty ugly.
also, a general post on investing in deflationary times vs inflationary times: www.marketfolly.com/20...
> "Summing up, deflation first, followed by inflation. Details on timing
> to be determined. Next question."
> The question then becomes: Why isn't the market discounting the future
> Another guess would be that the liquidating
> forces of the unwind are so massive as to dwarf investment buying
> of the "inflation later" theme.
Yes.
No. It's much worse than that.
Refer to Economic Report of the President table B-79. As a percentage of GDP, the national debt has increased from it's post WWII low of 32.6% 1981 to 50% in 1987 to 60% in 1991 to about 68% today (higher really, based on a shrunken economy).
"Summing up, deflation first, followed by inflation. Details on timing to be determined. Next question."
Don't think so. The Fed and treasury have made it clear that deflation will be prevented by any means necessary. Significant inflation is likely, but not certain. Here's an example of why.
The Fed is actively buying Treasuries and now agency securities, and has indicated a willingness to buy other types of debt, paying for them in new dollars. This should be inflationary, but in today's environment, it's counter-disinflationar... (same thing, just with a different starting point). This is just what the doctor ordered. In the future, as the economy comes back to life and private money creation returns, the excess Fed-created money that's buying debt should contribute to too-fast growth in the money supply -- unless the Fed exchanges the debt for money and takes that money out of circulation.
Here's where the fun part starts. If the Fed has to sell securities to pull cash out of circulation, there will be more debt on the market, yields will tend to rise as buyers have more options, and interest rates would rise, which would slow the economy, reducing inflation. But the problem then is that we might not be able to grow the economy very quickly without inflation becoming a problem.
There's a good answer, however. Suppose we gaze into a magic ball and find that the economy will stop contracting in 12 months and will really pick up speed in 24. The Fed could concentrate its debt purchases on those bonds that mature in 12-36 months. As long as the yield curve remains intact, interest rates across the board fall in response to the additional buying. And as the economy begins to grow, the Fed is repaid for the debt it has bought, and removes that money from circulation.
A mechanism for money supply contraction is in place to counteract the private money supply growth that will occur as the economy recovers. And there is no negative impact on interest rates that would come from the Fed selling debt as the economy recovers.
The Fed is essentially borrowing future money supply growth - which is desperately needed now - and then repaying it as the economy recovers. Short term impact on inflation? Positive. Long term impact on inflation? Zero. The trick comes in getting the timing right.
Don't expect miracles along these lines. But at the same time, don't expect disaster. These people are not morons.
On Jan 06 02:32 PM GloomBoom wrote:
> Shoveling money into the economy is NOT the way out of this. Let
> the economy deflate. That is what it will do anyway, since infrastructure
> spending will not help. It will just leave us poorer.
On Jan 06 02:32 PM GloomBoom wrote:
> Shoveling money into the economy is NOT the way out of this. Let
> the economy deflate. That is what it will do anyway, since infrastructure
> spending will not help. It will just leave us poorer.
On Jan 06 02:49 PM BS Detector wrote:
> "As a percentage of GDP, federal debt is roughly at the depths reached
> in the 1980s..."
>
> No. It's much worse than that.
>
> Refer to Economic Report of the President table B-79. As a percentage
> of GDP, the national debt has increased from it's post WWII low of
> 32.6% 1981 to 50% in 1987 to 60% in 1991 to about 68% today (higher
> really, based on a shrunken economy).
>
> "Summing up, deflation first, followed by inflation. Details on timing
> to be determined. Next question."
>
> Don't think so. The Fed and treasury have made it clear that deflation
> will be prevented by any means necessary. Significant inflation
> is likely, but not certain. Here's an example of why.
>
> The Fed is actively buying Treasuries and now agency securities,
> and has indicated a willingness to buy other types of debt, paying
> for them in new dollars. This should be inflationary, but in today's
> environment, it's counter-disinflationar... (same thing, just with
> a different starting point). This is just what the doctor ordered.
> In the future, as the economy comes back to life and private money
> creation returns, the excess Fed-created money that's buying debt
> should contribute to too-fast growth in the money supply -- unless
> the Fed exchanges the debt for money and takes that money out of
> circulation.
>
> Here's where the fun part starts. If the Fed has to sell securities
> to pull cash out of circulation, there will be more debt on the market,
> yields will tend to rise as buyers have more options, and interest
> rates would rise, which would slow the economy, reducing inflation.
> But the problem then is that we might not be able to grow the economy
> very quickly without inflation becoming a problem.
>
> There's a good answer, however. Suppose we gaze into a magic ball
> and find that the economy will stop contracting in 12 months and
> will really pick up speed in 24. The Fed could concentrate its debt
> purchases on those bonds that mature in 12-36 months. As long as
> the yield curve remains intact, interest rates across the board fall
> in response to the additional buying. And as the economy begins
> to grow, the Fed is repaid for the debt it has bought, and removes
> that money from circulation.
>
> A mechanism for money supply contraction is in place to counteract
> the private money supply growth that will occur as the economy recovers.
> And there is no negative impact on interest rates that would come
> from the Fed selling debt as the economy recovers.
>
> The Fed is essentially borrowing future money supply growth - which
> is desperately needed now - and then repaying it as the economy recovers.
> Short term impact on inflation? Positive. Long term impact on inflation?
> Zero. The trick comes in getting the timing right.
>
> Don't expect miracles along these lines. But at the same time, don't
> expect disaster. These people are not morons.
On Jan 06 02:32 PM GloomBoom wrote:
> Shoveling money into the economy is NOT the way out of this. Let
> the economy deflate. That is what it will do anyway, since infrastructure
> spending will not help. It will just leave us poorer.
The fed has 3 tools to manage the money supply:
1. Interest rates for overnight bank loans.
2. Open market activities.
3. Setting bank reserve requirements.
With interest rates near zero and changes to reserve requirements not feasible, the fed is left with its most useful tool, open market activities. To increase the money supply (and fight deflation) the fed creates money and buys things in the open market. This adds to the amount of cash available in the market. There are no limits to how much money it can create or how much stuff it can buy. Usually it buys government debt, but lately it has been buying all sorts of things, like mortgages. There is no limit to the amount of money that the government can create, so unless they screw up and do the exact opposite (e.g. the depression) the govt. can always kill deflation.
To decrease the money supply (and fight inflation), the fed would sell these assets in the open market, thereby reducing the number of dollars available in the market. If the fed actually managed to sell everything it owned and was still concerned about inflation, it could always raise interest rates (usually the fed operates both tools at the same time). In the early 80's, double digit inflation was quickly extinguished by double digit interest rates.
This is basically the government's playbook for the next 3 years: fight deflation first by buying assets and increasing the amount of cash in the market, then fight any resulting inflation by selling those assets and raising interest rates, reducing the amount of cash in the market.
As an investor, this means I am buying things that will increase when inflation and interest rates rise: TBT, PST, & TIP, but make your own decisions.
On Jan 06 03:07 PM dw57 wrote:
> so what tools does the FED and treasury have other than interest
> rates (which so far have been a non-factor) and spending money to
> fight deflation? once it starts, there is nothing else they can do
> is there?
Another guess is that a few large buyers have got wind of the possibility of some dreadful geopolitical event.
One thing we can be relatively certain about is that the strong and smart will outfox and out compete the weak and stupid, in the long run, and they will make use of whatever opportunity arises.
Some people call it capitalism and free enterprise and other people call it Social Darwinism and the law of the jungle.
Whatever you call it, being certain about the future is more like whistling in the dark than sound financial planning.
Inflation or deflation, the intelligent and strong will profit and the weak will suffer.
Traditionally, liberal politics and economics have tried to mitigate this situation and radical politics and economics have tried to change it.
By world standards, America has been conservative in both politics and economics since World War II, at least.
But who knows what the future holds ;)
Deflation is no where to be found . 1 year ago, Pepsi raised prices 25% . bam, just like that. again this year, another 25 % increase . my internet service provider just sent me notice my monthly bill goes up 25 % next month. food costs have gone up an average of 15 to 20 % in just the past 6 to 8 months. Sure, gas and oil have come down ,but nothing else has. commodities went up 40 % in 6 months and have dropped maybe 10 to 15 % since then ,but are still way ahead of last year.Utility costs are up 20 % or more since last year and heading higher .Come on show me this deflation you scare mongers keep harping about or shut up .