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On January 20, The Inflation Trader published an article on Seeking Alpha entitled "How Inflation And Deflation Can Peacefully Coexist." I'm not going to address directly the content of that article here, but I do want to borrow its title as a takeoff point for a different discussion. Inflation and deflation are indeed coexisting right now, although in my judgment without anything resembling lasting peace in their relationship. To embellish a bit on the Cold War metaphor, there are nuclear weapons in the background and nervous policymakers with fingers close to the trigger buttons. Let me try to explain.

Price Stability is a Statistical Illusion

Various writers today warn darkly about inflationary or deflationary "tendencies" in the market. This is vague terminology, which, as best I can tell, usually refers to forces a particular author believes to be at work in the economy that should be causing a general movement in prices but for some reason is not. Pundits with opposing biases currently talk a lot about tendencies towards either deflation or inflation, even though at least within the U.S., prices have in the aggregate have exhibited neither to any worrisome degree. They have in general been fairly stable - one would think an ideal state for this particular variable.

The real problem is that, like most macroeconomic concepts, aggregate inflation and deflation are abstractions that morph into very different animals as we make them concrete. Anybody in recent years having to cope disproportionately with uninsured medical expenses or college tuition, for example, has experienced a nasty inflation. People buying big screen TVs or other electronic gadgets at the same time have experienced deflation. The Consumer Price Index and other popular averages, by the nature of what they are, average all this stuff out, along with food, housing and so forth, to produce artificially homogeneous data that is never quite what it appears to be. It covers up a very discordant reality.

Why We Fear Deflation

It's currently in vogue among liberal economists to dwell on the dangers of deflation, while conservatives continue to fret more, as they always have, about inflation. It may not be immediately obvious why there should even be a political battle line down the middle of this issue, since deflation lowers the cost of living and might therefore be imagined as good for everybody, especially the lower and middle classes. However, the matter is in no way that simple, because whatever benefit may result from deflation is overwhelmed by the concurrent damage it does in its impact on debtors. With deflation, debt service becomes increasingly burdensome with time because the debtor's income is deflating while the hard debt service nut looms ever larger by simply remaining the same. This dynamic can quickly ruin overleveraged borrowers, including companies and governments, and, if it persists long enough, trigger bankruptcies, depress wages and cause people to lose their jobs. Hence, the special concern among liberal economists, who generally try to position themselves as guardians for working people. Deflation can become a self-feeding viral phenomenon if allowed to establish itself. In a system like ours in the U.S. today, where arguably everybody from consumers to municipalities to the federal government itself is overleveraged, this scenario is indeed something to ponder warily.

The Fed's Curious Re-Birth

Which of course brings us to the current mindset of the U.S. central bank, seemingly in our era the alpha and omega for every discussion about finance and economics. While the Fed was traditionally viewed as a bastion for conservative inflation-fighters, a transition has been underway now for some time. Ever more accommodative monetary policy started becoming the norm even under Alan Greenspan, the one-time Ayn Rand disciple who was billed initially as the quintessential embodiment of conservative central banking. Ben Bernanke came into office also emitting a conservative aura, even as he waded loyally right into Greenspan's footsteps, which were by then awash in loose money. Bernanke was later hammered by the 2008 financial crisis and never blinked an eye before pouring an ocean of money onto the fire. Even though the fire has now gone largely underground, the liquidity ocean remains and is being expanded. Short-term rates stand effectively at zero and long-term rates are being manipulated downward by quantitative easing, a heretofore obscure central banking tool that is currently channeling a steady stream of new money into an already very liquid banking system. Once considered a radical tool, Quantitative Easing is now talked about as though it were as normal as apple pie.

A Two-Pound Screwdriver

For investors, the point is that loose monetary policy is here to stay, whatever tepid chatter we may hear about "tapering." In a bitterly partisan political environment, easy money seems to be one of the few policies that has any semblance of consensus backing it in Washington. It was telling that in what has been probably the most important nomination coming out of President Obama's administration, Janet Yellen was approved as Fed Chair with little more than token opposition. Lesser Obama appointments tangled up the U.S. Congress virtually in constitutional crisis last year. Like Bernanke before her, Yellen has vowed continuity with existing Fed policy.

While earlier Fed governors generally spoke in terms of acceptable ceiling levels for inflation, the Fed now instead has an inflation "target." Low aggregate inflation data might once have been embraced proudly as evidence of price stability, the Fed's historic raison d'etre. Similar data is now viewed with near panic as evidence that we're steering too close to the dreaded cliff of deflation. Price stability is ironically something the Fed feels impelled to fix. Unfortunately, the tools it has for doing so are as crude as they are powerful. In doing its work, the Fed is like a watchmaker digging into complex mechanisms with a hammer and a two-pound screwdriver.

Investors Should Expect Deja Vu

Unintended consequences abound whenever the Fed exerts its power. For one thing, by focusing on aggregate data and seeking a target, the Fed risks driving up prices in certain sectors, like medical services, that are already outliers on the high side, thus inadvertently destabilizing important areas of the economy. For another thing, and of more immediate importance to investors, the Fed will continue creating asset bubbles. The Fed plies its monetary tools, including QE, through its network of primary dealers, who in turn make markets for the public. These money flows are largely hidden from view and too complex to be analyzed effectively even if they could be seen. However, money like water will always find channels somewhere, and it's clear that all this new money has been driving up asset prices. Stocks in the aggregate have already surpassed their pre-crisis levels and even home prices, ground zero for the 2008-09 turmoil, have rebounded sharply in many areas.

Thus, the very trends that post-crisis moralizing told us were so reckless before, are accelerating again. The Fed, however, has its eye on deflation and will keep pumping liquidity into the system until another major dislocation occurs or until deflation is definitively beaten back. Unfortunately, should the latter event occur, we may find ourselves once again coping with some species of virulent inflation, since the Fed's crude tools are probably incapable of engineering in the real world the kind of clean equilibrium that economists see in their models.

Source: Deflation, Bubbles, And Our Unresolved Crisis