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The financial crisis and the subsequent recession have sparked a continuing debate on inflation and deflation. To date, the fears of deflation among policymakers and economist have been more profound than the prospects of inflation or hyperinflation. This, despite the fact that the U.S. adjusted monetary base has expanded by nearly $2.2 trillion and government debt by nearly $8 trillion after the crisis. This article discusses the reason for inflation remaining muted in the United States amidst ultra expansionary monetary policies of the central bank.

As mentioned above, the charts below give the adjusted monetary base and the government debt in the United States.

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The monetary base is significant because it indicates expansionary or restrictive policy action of the policymakers. Very clearly, policymakers have been trying to flood the economic system with liquidity after the financial crisis. The U.S. government debt is also significant as deficits result in additional liquidity flow in the global financial system. The significance of ballooning government debt on liquidity is underscored by the fact that the total currency based global reserves have doubled to $11.2 trillion in the third quarter of 2012, from $5.6 trillion at the beginning of 2007.

Amidst all these inflation-friendly factors, deflation concerns still seem to be significant. Yields on 10-year Treasury bond, currently at 1.65%, speak volumes about market participants' perception of inflation. The decline in gold, to some extent, reflects a near-term deflation concern.

This poses a critical question for analyst and investors: Why deflation fears are predominant in an environment characterized by easy monetary policy globally?

The answer to this question comes largely from the way the banking and financial system works today. Before I discuss the functioning of the system, I would like to present a chart, which gives the excess reserves of depository institutions with the Fed.

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The excess reserves with the Fed have swelled to $1.7 trillion as of March 2013. This chart is of extreme significance as it puts things well into perspective. On one hand, policymakers are trying to ease liquidity and lending in order to boost growth. On the other hand, banks are tightening lending standards in order to prevent further losses. Banks are finding it more lucrative to earn a 25bps interest on excess reserves than to lend the money to households. Credit growth therefore remains weak even with interest rates at near-zero levels. This trend best explains the deflation fears. Things will be clear when the relation between credit growth and money is understood.

In order to explain the relation between debt and money, the workbook on "Modern Money Mechanics" [pdf] by the Federal Reserve Bank of Chicago serves a good purpose. According to the document -

Changes in the quantity of money may originate with actions of the Federal Reserve System (the central bank), depository institutions (principally commercial banks), or the public. The major control, however, rests with the central bank. The actual process of money creation takes place primarily in banks. As noted earlier, checkable liabilities of banks are money. These liabilities are customer's accounts. They increase when customers deposit currency and checks and when the proceeds of loans made by the banks are credited to borrowers' accounts.

The most important point I want to highlight here is that the actual process of money creation takes place primarily in banks. Further, money creation will happen only when there is robust credit growth. Under the fractional reserve banking system (assuming 10% reserve requirement), $10,000 loaned into the system can multiply 10 times through subsequent transfers and lending. The key is robust economic activity, which spurs credit growth and results in the swift changing of hands for digital money. The graphic below gives a good illustration of how money would multiply under the fractional reserve banking system.

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If we explain the process in very simple terms, it can be said that debt is money under the modern banking system as one loan can multiply the money several times over. For this to happen the banks must lend and businesses and households should borrow. Unfortunately, the money turnover is at multi-decade lows indicating very weak real economic activity.

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Also, the excess deposit of banks with the Fed indicates that banks are not willing to lend. At the same time, consumers and businesses are less likely to borrow with real economic activity and unemployment (U6) remaining weak. What follows is - When there is no debt, there is no money.

This explains why central banks have failed to generate the desired level of inflation in the real economy even after ultra expansionary monetary policies. I am talking about healthy inflation and not inflation triggered by speculation in different asset classes.

The current scenario also suggests that the expansionary monetary policies of the Fed are futile as banks have tightened lending standards and a majority of money is created by the banking system. A clear conclusion is that deflation concerns will only subside when bank lending is relatively robust.

I have to point out here that the current scenario does not necessarily mean that we are staring at asset deflation for the long term. Banks and financial institutions have ample liquidity to speculate in different asset classes. Even central banks are active participants in equity exposure as they seek to diversify their reserve holdings. What this scenario implies is that the Fed can do practically nothing for the real economy and the current policies just benefit banks and financial institutions.

Investors also need to understand that artificially low interest rates would imply that risk needs to be taken in order to preserve the purchasing power of money. It is therefore important to consider exposure to equities on correction. I do expect equities to decline over the next 3-6 months. If markets do correct meaningfully, investors can consider exposure to the following stocks and ETFs -

SPDR S&P 500 ETF (SPY) - It has been proven that beating the index is not an easy task. Therefore, the strategy should be simple -- beat the index or invest in the index. From this perspective, SPY looks interesting. Also, with excess money flowing into risky asset classes, the S&P should trend higher over the next 3-5 years. Therefore, the expected correction can be used to consider fresh exposure to the ETF. The ETF provides investment results that, before expenses, generally correspond to the price and yield performance of the S&P 500 Index.

Johnson & Johnson (JNJ) - is a good investment option. I like this highly diversified healthcare company, with products as well as regional diversification. Further, the sector catered to by JNJ is not very prone to economic shocks. JNJ has been a good dividend payer in the past, with a dividend yield of 2.9%. In my opinion, the stock is excellent for a long-term portfolio. It also commands a higher rating than the U.S. sovereign rating.

BP Plc (BP) - is an attractive long-term buy due to several reasons: excellent and diversified asset base, presence across the value chain, presence in alternative investment themes and a good dividend yield of 5.1%. Further, the TTM P/E is at an attractive level of 11.75. Overall, BP is well positioned to take advantage of the long-term appreciation in crude oil prices.

Apple Inc (AAPL) - can be considered to be a relatively good dividend investment option more than a growth stock option. The stock is currently trading at an attractive PE of 10.3 with a dividend yield of 2.9%, which will improve further over the next quarters. Also, with the next line of products to be rolled out in autumn 2013, and in 2014, the stock might consolidate at current levels before the next significant move on product announcement and subsequent market response.

Source: Because Debt Is Money