Why Deflation Will Persist for Longer Than You Think 33 comments
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One of the most hotly watched economic indicators is the Consumer Price Index (CPI), as it is a proxy for inflation in the US economy. This is an extremely important number, especially given the state of the US consumer and its impacts on yields in the fixed income markets. At the beginning of the year, with sky rocketing commodity prices and increasing food prices we were looking at a period of extreme inflation during the beginning of a downturn, of which we knew very little about. Ever since the collapse in commodity prices and devaluation of every asset class known to man, we have seen a major change from what this indicator has been telling us. It paints a picture of a time of what could be one of the most deflationary environments ever seen in our economy, as the past 3 months have seen negative CPI prints, signaling extreme deflation.
With the Fed undertaking a policy of quantitative easing to stimulate the US economy and the credit markets, many people claim that we will be seeing a very inflationary environment in the near future. The question is, how long can and will deflation persist for, and what are some of the things that will drive inflation or deflation going forward? It is my opinion that we will continue to be in this extremely deflationary environment longer than people think, but let’s see why.
- Unemployment/Lack of Consumer Spending - The current state of employment in the US economy and the prospect of it going forward paint a very deflationary picture. With the unemployment rate ticking up to 7.6% and over 3.6 million people having lost their jobs in the past 12 months, with more and more job cuts coming from companies every day, the chances of the US consumer making up over 70% of GDP like they have in the past is extremely unlikely (they were 63% in the latest report). This is extremely important for inflation/deflation forecasters to keep in mind. While many pundits love to scream that the quantitative easing policies taken by the Fed to stimulate the economy are extremely inflationary, one has to keep in mind that it’s not only the supply of money that matters, but the velocity of money (the rate at which it is spent) too, which has collapsed. Until we see the velocity of money pick up, which stimulates the multiplier effect, we will continue to be in an extremely deflationary environment.
- Excess Capacity - As of now there is almost $1 trillion in excess capacity in the economy (aggregate supply is $1 trillion greater than aggregate demand). This is an extremely deflationary condition and should persist, unless the consumers can somehow snatch up this $1 trillion of capacity in a short amount of time: I would not count on that.
- High Inventories - While the latest GDP report came in better than expected at -3.8%, the internals of the report were absolutely terrible. Most of the difference between the real number and consensus was due to much higher inventories (consensus was calling for a $100 billion decrease in inventory, but there was a $6.2 billion increase). This could mean two things: companies are stockpiling inventory in hopes of selling it in the coming quarter (yeah right) or they just can not get product off the shelves (this one sounds right). This has caused many economists to essentially flip-flop their 4Q08 and 1Q09 GDP predictions, as some are calling for nearly a -6% GDP decline in 1Q09. This huge inventory buildup is extremely deflationary, as companies likely will not be able to get product off shelves, especially given the state of the current US consumer, causing an even bigger build up of inventories, causing prices to come down and further deflation.
- Increase in the Savings Rate - Since September the savings rate has tripled (from 1.2% to 3.6%), which in and of itself is extremely deflationary. Given the fact that almost every consumer in the US is de-leveraging their balance sheet, paying down debt and increasing savings with any type of added wealth, the prospects of this money actually hitting the economy, GDP wise, is extremely low, and would not help increase the velocity of money, further strengthening deflation. This is one of the problems with the stimulus plan and its proposed $275 billion tax cut. It increases the wealth of the consumer, not the income. Consumers will be more inclined to save added wealth, as opposed to an expected increase in future income, which would help stimulate the economy better, by inducing expenditures on the consumers part.
- Housing Prices - Housing prices have only come down approximately 25% and the level most economists are looking for in terms of reaching equilibrium is for housing prices to fall 40% from their peak. Given the strong possibility that housing prices will continue to decline, by up to 15%, should help drive deflation going forward. So unless you think the housing market has bottomed, with supply still at 9.2 months (normal market conditions are at 6 months), then the likely decline in housing prices is very deflationary.
- Private Sector Debt/Income - The ratio of private sector debt to income is still at all time high levels of 140%! That is how highly levered this economy is and shows the depth to which the average consumer took on levels of debt they could not afford. In normal market conditions, this number is normally at 80%. Economists suggest that this could cause the consumers to unwind nearly $6 trillion of money in the system, as part of the de-leveraging process. If the need to get rid of trillions of dollars in consumer spending money is not deflationary, then I do not know what is!
As you can see there are many deflationary aspects of the economy that are not even close to working their way through the system over the next 3-6 months. This is going to be the toughest part of the recession as nothing can really speed up the de-leveraging process that banks and consumers are going through. The only cure is time and for the time being, until some of the above indicators improve, we should continue to see deflation persist in the US economy, probably for much longer than people think.
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This article has 33 comments:
With the current CPI data we can infer that the government is printing money at a rate equal to the reduction in the velocity of money i.e. no inflation. In other words, M is rising just as fast as V is going down.
However, historically, we see velocity as stable, so it will rise to its normal level once the economy starts off again. That should create an inflationary environment that the government will have to attack by reducing the money supply. It is doubtful they will be able to reduce it as fast as they are printing it, judging by the diminishing quality of their assets on the balance sheet.
Bottom line is inflation is not for now, unless the government continues on its printing spree, which is unfortunately very possible. But, as always, let's hope for the best, and prepare for the worse!
Jason
Trying to be cute by playing the deflation theme now is akin to trading internet stocks in early 2000 knowing "you'd get out before the collapse".
Easy to say... hard to do.
Here's a cut-and-paste of my previous reply to another SA dollar-bull article. I would truly appreciate your thoughts.
"Maybe I can get this author to explain why they will stop trying to reflate? In the face of vastly reduced tax revenues, many US states are beginning to flirt with BK. States cannot print. The US is similarly faced with both mounting debt (and the mounting debt service to go along with it) and reduced tax revenues.
Someone please offer me a rational explanation as to why this situation will be 'allowed' to continue, why at some point the central banks and treasuries of the world will say 'it's not working, so screw it' and how it will be resolved in a deflationary environment.
What will happen to the debt?
How will it be paid?
If it is not paid, what happens to currencies in national defaults?
If you believe there will be a deflationary spiral and still no default, how will the defaults be avoided? Where will money come from to service debt?"
Inflation is tax, paid by the rich and poor. Don't think Obama is good for the poor, he will tac them with inflation, the same rate as the rick. But few economists knew.
Rich stock owners paid half of their asset already during this Bear Market. Since inauguration, DOW coming down 1000 point, that is 1000 billions loss, balanced the bailout cost very well.
Our mess was from our over spending, can Congress leads us out of this mess they created, with mroe spending that we don't have?
There is no way out except we make our own shoes and grow our own tomatos. There is no more $25.00 an hour job if Chinese can do everything cheaper. And there is almost nothing we can do and they could not do..
And companies that are barely hanging on will be loathe to cut prices. Ask any turnaround executive what to do with a money losing company- step one, increase prices. If the market doesn't give you the pricing power to implement these, then get out of the market. Thus, supply capacity will be destroyed. Creating more unemployment.
The opposite conditions apply in an inflationary environment- economies of scale and wages rising slower than income mitigate pricing pressures. However, if too much supply capacity is destroyed, these factors won't be as strong.
We need to inflate quickly and allow the dollar to weaken so we can use more capacity to pay foreigners off. As for what we'll do- we have significant comparative advantage in agriculture (and derivative products), pharmaceuticals, entertainment, construction equipment, aerospace, and software, so we don't have to make shoes- we can still just design them.
1) Commodity production - mines, oil wells, agriculture are being shut down, suffering fro lack of capacity investment, or restricted by credit so we are reducing our supply which will drive up prices sharply at some point.
2) One of the anti-inflationary arguments has been that banks are hoarding the cash from the government and not lending. Once that changes, and the media event yesterday is an example of how it is being forced to change, we will see a flood of money into the syetm with an attendant velocity increase.
3) Don't discount importing inflation. During the 1990s we imported deflation as our dollar was very strong and we loved that. Now the worry must be importing inflation. China's CPI is now down towards 1%, new bank loans have risen fro three months straight, their central bank has lowered rates aggressively and will do so again as their CPI is so low. Their banks, industries, and consumers are not impaired by debt as ours are. Look to inflation to pick up in China and it finds its way to the US through our imports.
Unfortunately the result of all this may very well be stagflation; high inflation without an increase in nominal wages.
"Unemployment/Lack of Consumer Spending" "Excess Capacity" "High Inventories" "Housing Prices" "Private Sector Debt/Income"
The author is correct, but investors should prepare for the opposite. In the face of deflation, I would prepare for inflation. Most people do not understand how MUCH non-existent "virtual" money is being printed, and how much unpayable debt the USA has accrued.
The first time that virtual fake money starts to move, latent inflation will take off like a rubber band pulled waaaaaay back by deflation.
The FED reaction mentioned will come *intentionally* a day late and a dollar short:
The USA cannot pay its debts without diluting them by massive inflation.
This being seekingalpha.com there is no shortage of people that "know" the answer to this, but as always time will tell the true story and we will have to cope with the outcome.
Remember, research has shown that government policy actions are almost irrelevant in the longer term that all investors live in, once again it is a speculators market.
Tell that to the Germans in 1923, or the Argentines, or those in Yugoslavia, the Soviet Union, etc. A determined government can always produce inflation - and this government seems mighty determined.
A foolish comment from someone who prefers to cater to what they know instead of what is. Just because you haven't seen deflation in your lifetime is no reason to pretend it does not exist.
This article is correct in that all of the deflationary forces will outweigh the inflationary forces for quite awhile. Let's check back in a year or two and see who is right, shall we?
It's fairly obvious the outcome will induce a lending contraction due to the expansion of monetary deflationary stimulus.
I also notice that inflation is still strong in the medical sector. Both activities are highly controlled by the government and both sectors use income from the winners to cover losses from the losers.
Think about the incremental moment when global consumers realize they are sitting on piles of cash with declining inventories...and by consumers, I'm talking about all the foreign holders of US paper.
1 not only has velocity decreased but the amount printed (or even obligated) still seems small compared to money destroyed so far.
2. would be constructive to estimate that fraction (printed to destroyed money) since 1. its probly easier then estimating velocity but has the same effect and 2. no inflation can begin without the ratio making some kind of convincing headway towards 1.
What is the best source for tracking the velocity of money?
thanks.