The Short Term Case for Long Term Deflation

Co-Written by Lorn Davis

At Portfolio Asset Management we see the current short-term deflation leading to longer-term inflation. While we think inflation is inevitable, let’s drill down on the argument that long term deflationists are making and extrapolate from there. For inflation bulls, it is good to know what the other side’s arguments are, and for deflation bulls, we’re going to tell you what you want to hear! Of course we won’t know for sure who is right for another couple years.

We begin with Friedman’s view that money determines nominal income with a lagging period of 5-22 months. This is important because of Wall St.’s worry about the Fed’s recent quantitative easing and injection of capital. So far the increase in reserves has largely sat in the banks doing little to promote lending. That’s why we’ve seen the steady march in mortgage rates over the past few months to 5.5% and higher. Meaning, the banks really don’t want to lend it all out, or can’t find decent people to lend to. It’s our belief that rates have peaked for the short term with the 10-year treasury at 4% this week.

In addition, Friedman said that the monetary base determined nominal income, not prices. With a weakened labor force we should see increased output as opposed to higher wages. This has happened recently. Of course higher wages would lead to higher prices and ultimately core price inflation. So even though payroll reports are showing “slowing” unemployment, the fact of the matter is the work force is deteriorating at a rapid rate and those with jobs aren’t seeing any raises.

To complement the increasing unemployment rate, last week’s Beige Book told us that “labor market conditions continued to be weak across the country, with wages generally remaining flat or falling.” This is our short term deflationary pressure, wages falling around the country and leading to falling prices. Of course the deflation-bulls ascribe to Friedman’s belief in the time lag between income and the Fed’s quantitative easing to be on the tail end of estimates. Effectively, we won’t see relief for at least half a year or more. In the mean time we’ll be in a state of core price deflation as the stock market continues to putter around demonstrating the lack of economic growth and capital circulation.

The bottom line is we will not see the wage/price spiral until at least next year. Now, long-term, you can extrapolate and say banks will not start loose lending for many years, and demand from the third world will remain flat. We don’t think this will happen, but deflation bulls have a lot of ammunition to make the case. How can you play this trend? Be long treasuries (TLT) and keep a good amount of cash. Not great.

Full Disclosure: None.

Comments

[Larry House:]

It goes against my grain to be long Treasuries now. I think inflation is the greater threat. I would have to have more evidence of deflation before I want to hold Treasuries and cash.

Jun 16 03:07 PM

[odin:]

In modern times, when houses, cars and all manner of consumables get bought on credit, its growth/decline becomes a more reliable indicator of inflation than purely money supply.

In the past (as under constant velocity conditions), money supply has been a good proxy for credit growth. In recent history, it has even understated the case for inflation around the world as shadow-banking took hold. On the flip-side, we now have shadow-banking assets moving back on the books in some places overstating the level of lending going on.

I dont think we can rely on money supply entirely to make the case for inflation or delfation any longer as the velocity of money is no longer stable.

The inflation/deflation equation will be predicated on where economic growth and credit growth balance. Right now, it does seem that credit is contracting faster than the economy (deflationary).

Jun 16 04:07 PM

[capitalisth...:]

I think the better play is to divest yourself of dollars and t-bills and buy commodities. Commodities are a win win. If the economy recovers then there will be a greater demand for commodities. If hyperinflation occurs, then commodities are a great hedge.

Also, realize that deflation is very bad for debtors because it increases the cost of servicing their debt. The U.S. govt. is the biggest debtor the world has ever known. The govt. cannot allow deflation because it would make its debt even more unmanageable than it is now with moderate inflation.

Jun 16 04:11 PM

[six:]

Less people working + people working making less money + more money being saved = ???
How freaking stupid can the world be? Inflation is too much money chasing too few goods/services. Just because more money is being printed means NOTHING if it is not being spent. And money is NOT being spent, check the numbers. To have real inflation you have to have DEMAND. Prices can not rise without demand. What in the above equation equates to increased demand.
DEFLATIONARY DEBT DESTRUCTION

Jun 16 04:43 PM

[Lee Eugene ...:]

Looking at the yields of the ten year tracking down to the 3.7 range shows that investors are less concerned with inflation this week. And hedge funds running with commodities recently makes us pause to see if there really is innate demand, which doesn't seem to be true. And as we noted, this is on the short term. Inflation seems to be the long term phenomenon we're expecting.


On Jun 16 03:07 PM Larry House wrote:

> It goes against my grain to be long Treasuries now. I think inflation
> is the greater threat. I would have to have more evidence of deflation
> before I want to hold Treasuries and cash.

Jun 16 06:08 PM

[dcb:]

this is false. just think through it.


On Jun 16 04:43 PM six wrote:

> Less people working + people working making less money + more money
> being saved = ???
> How freaking stupid can the world be? Inflation is too much money
> chasing too few goods/services. Just because more money is being
> printed means NOTHING if it is not being spent. And money is NOT
> being spent, check the numbers. To have real inflation you have
> to have DEMAND. Prices can not rise without demand. What in the
> above equation equates to increased demand.
> DEFLATIONARY DEBT DESTRUCTION

Jun 16 06:12 PM

[dcb:]

not correct. you need to look at who is doing the buying. check out tyelr durdens posts. he shows the fed is doing a lot of the buying. this means nothing and suggests increasing inflation instead of less.


On Jun 16 06:08 PM Lee Eugene Munson wrote:

> Looking at the yields of the ten year tracking down to the 3.7 range
> shows that investors are less concerned with inflation this week.
> And hedge funds running with commodities recently makes us pause
> to see if there really is innate demand, which doesn't seem to be
> true. And as we noted, this is on the short term. Inflation seems
> to be the long term phenomenon we're expecting.

Jun 16 06:14 PM

[dcb:]

an almost doubling of the price of commodities since march 9th tells me "inflation" bespoke did an analysis on oil and this is the fastest it has ever risen.

look at the price at the pump!!
we many have one period of YOY deflation, that will be it and that is next to nothing!!

Jun 16 06:17 PM

[Lee Eugene ...:]

This is an interesting point. We'd love to see more on this, perhaps you could write on it. We're wondering about how you are differentiating credit from the money supply in so far as you claim that the velocity isn't stable now because we still believe credit is a 2nd derivative of the money supply, and wouldn't use it as the primary determining factor.


On Jun 16 04:07 PM odin wrote:

> In modern times, when houses, cars and all manner of consumables
> get bought on credit, its growth/decline becomes a more reliable
> indicator of inflation than purely money supply.
>
> In the past (as under constant velocity conditions), money supply
> has been a good proxy for credit growth. In recent history, it
> has even understated the case for inflation around the world as shadow-banking
> took hold. On the flip-side, we now have shadow-banking assets
> moving back on the books in some places overstating the level of
> lending going on.
>
> I dont think we can rely on money supply entirely to make the case
> for inflation or delfation any longer as the velocity of money is
> no longer stable.
>
> The inflation/deflation equation will be predicated on where economic
> growth and credit growth balance. Right now, it does seem that
> credit is contracting faster than the economy (deflationary).

Jun 16 06:19 PM

[Lee Eugene ...:]

The current issue we have with commodities is if demand truly exists or ramped up by the stampede. We're cautious until given more evidence.

The second point is spot on and one of the reasons we don't foresee deflation for the future.


On Jun 16 04:11 PM capitalisthero.com wrote:

> I think the better play is to divest yourself of dollars and t-bills
> and buy commodities. Commodities are a win win. If the economy
> recovers then there will be a greater demand for commodities. If
> hyperinflation occurs, then commodities are a great hedge.
>
> Also, realize that deflation is very bad for debtors because it increases
> the cost of servicing their debt. The U.S. govt. is the biggest
> debtor the world has ever known. The govt. cannot allow deflation
> because it would make its debt even more unmanageable than it is
> now with moderate inflation.

Jun 16 06:27 PM

[Lee Eugene ...:]

Absolutely, thank you for getting to the heart of the matter. No demand, no inflation. All this crap about China is just digging a hole and filling it again. Love the comment.


On Jun 16 04:43 PM six wrote:

> Less people working + people working making less money + more money
> being saved = ???
> How freaking stupid can the world be? Inflation is too much money
> chasing too few goods/services. Just because more money is being
> printed means NOTHING if it is not being spent. And money is NOT
> being spent, check the numbers. To have real inflation you have
> to have DEMAND. Prices can not rise without demand. What in the
> above equation equates to increased demand.
> DEFLATIONARY DEBT DESTRUCTION

Jun 16 06:33 PM

[Lee Eugene ...:]

I'm a big fan of zero hedge, but I'm not a fan of his point about inflation. I also don't like people using pseudonyms from one of my favorite movies and hiding behind a Bloomberg. I question somebody who is clearly a sophisticated operator but doesn't publicly expose themselves...

On Jun 16 06:14 PM dcb wrote:

> not correct. you need to look at who is doing the buying. check out
> tyelr durdens posts. he shows the fed is doing a lot of the buying.
> this means nothing and suggests increasing inflation instead of less.
>

Jun 16 06:37 PM

[grey road:]

I think what everybody misses is the fact this is not like anything we have seen before and its really really bad. I do not see any way out... It will be a bad outcome with both inflation and deflation( i dont know if this is stagflation but whatever) The cost of many things will go up. The relative value of your money will decrease. The value of real estate and stocks will be stagnant. It is times like these that even history cant tell the whole tale but i notice most of you don't have the ability to look past your current working life. There is not much the government, the fed or anyone can do to stop the long term decline in the US economy. It will truly be a new way of life in many respects. Not taking it seriously will only make it harder for one.

Jun 16 06:41 PM

[Mad Hedge F...:]

Here's a big long term case. I couldn’t help but laugh when I saw my old colleague from Morgan Stanley, Stephen Roche, on CNBC today. The current chairman of Morgan Stanley Asia (MS) is bearish on the economy and sees no chance of a “V” shaped recovery, just a very weak one at best. There are no “green shoots”, they’re still underground. “The consumer is toast”, he averred, and he expects consumer spending to plummet from a record 72% of GDP to 67% in five years. Because a massive external deficit has to be funded by foreigners, the outlook for the dollar is “down, down, down.” There won’t be a crash, just a gradual decent, as we have seen for the last 38 years. China isn’t going to bail us out. The US has only 4.5% of the global population, but accounts for $10 trillion of consumer spending. China and India together have 40% of the population, but only spend $2 trillion. This disparity is 50:1. Steve was an early BRIC fan, like me, and since China is so overbought short term, India is his first pick. You want to buy countries that have to build infrastructure and a middle class, and China has already done that. India’s recent election of a more pro business government is the trigger. I aggressively pushed India at the beginning of the year (www.madhedgefundtrader...), and it has doubled since then. The humorous thing about all of this is that Steve has been spouting the same perma bear line for the US for 15 years. The in-house joke at MS was that he was sent to China because his bearish sentiments were scaring the firm’s conservative US institutional investors. Given the performance of the BRIC’s since then, it is Steve having the last laugh.

Jun 16 06:46 PM

[jimboy:]

The inflationists are not "freaking stupid", just taking a longer and broader perspective. According to one series (research.stlouisfed.or...) there was a bit less that a trillion dollars out there in 1980 and now there are 10 trillion dollars. That right there is why you have 70$ oil in the midst of a global recession, politicians throwing trillions around like they're chump change and millions of employed middle class Americans scared they can't pay for college or health care. Every time a bubble bursts the Fed blows harder, the last pop you'll hear will be the dollar itself.

On Jun 16 04:43 PM six wrote:

> Less people working + people working making less money + more money
> being saved = ???
> How freaking stupid can the world be? Inflation is too much money
> chasing too few goods/services. Just because more money is being
> printed means NOTHING if it is not being spent. And money is NOT
> being spent, check the numbers. To have real inflation you have to
> have DEMAND. Prices can not rise without demand. What in the above
> equation equates to increased demand.
> DEFLATIONARY DEBT DESTRUCTION

Jun 16 06:53 PM

[Nathaniel C:]

I never understood the Keynsian argument that inflation pressures will not exist as long as employment is high and aggregate demand low. The bozo's at the Fed during the 70's kept saying this as the US experienced double digit inflation. Finally the Monetarists came along and said that it was the money supply stupid. If the central bank is printing trillions of dollars you will eventually have inflation (not necessarily in the short term).

I keep hearing this deflation argument but fail to see it in the real world. Energy, food, education, and healthcare are all going up. Is oil going from 147 to 75 deflation even though it was $10 in 2000? CPI and PPI are all saying that there is no inflation. The truth is that the US has experienced perpetual inflation since 1913. And by the way deflation (increase in purchasing power) is not a bad thing as the central bankers say. Look at the computer industry which experiences massive price deflation and yet they grow earnings and have high profit margins. The central bank propaganda is so good that people actually want inflation (decline in purchasing power). The sheeple will believe whatever the TV tells them. The dollar has lost 95% of its purchasing power since 1913 as prices increase every year despite increased productivity and technological advancement.

Jun 16 07:02 PM

[Fighting Yoda:]

All roads lead to Deflation

Fed can print all the money it wants - if there are no takers, and there are only few, the money sits in bank vaults - the "excess reserves" - 'liquidity trap'. All that is deflation. The printed money has to be transmitted to the consumers - the only mechanism is increase of nominal wages - but they are declining, along with falling employment.

Govt. is trying to pick up the slack in borrowing and spending - with stimulus and tax breaks - too little. The consumers are saving all the tax breaks and more.

Yes inflation is a monetary phenomena - money + credit is the way to measure it. As credit contracts more than increase in M1- money actually decreases - Deflation.

With worldwide excess capacity and worldwide recession (decrease in demand) - inflation is a very unlikely scenario - and all the evidence should be clear - unprecedented CPI/PPI drops worldwide - even in China.

In the long term we are all dead - leaving the debt to our children.

Jun 16 07:42 PM

[specks:]

What a shame.
Some people think their opinions are so important they repeat them in the struggle and prayer they'll be read thereby taking up everyone else's limited and precious time!
If you have something good to write, then write it once and move on.
Thanks Bud(s)!

Jun 17 03:25 PM

[ETF Grind:]

How many people are unemployed in Zimbabwe?

Jun 19 01:59 AM