The Deflation Debate
There’s been an ongoing dialogue about the effect of the Fed’s extraordinary liquidity activities over the last two years: inflation or deflation?
At the core of this disagreement is the real world departure from what monetarists would expect to occur as a result of a near-zero federal funds rate and a massive increase in the money supply.
While in ordinary economic times the Fed would need to raise rates in order to tame a deliberate rise in pricing, or inflation, these are not ordinary times. These are times of the worst financial crisis in 80 years. These are times of surplus capacity crashing with a spiked demand for cash. These are times of uncertainty.
As a result, there has remained significant slack in the economy while there has also been significant hoarding of cash by banks, companies, and consumers. The toxic stew born of such a situation is a system awash with stagnant money as I first pointed out in Where’s the Velocity? Why the Fed Is Fighting Slow-Moving Money and Not Inflation on March 1 of this year.
And the slower money moves, the slower money changes hands, the greater the risk deflation becomes as economic activity and demand for the products of that activity invariably slow. In turn, this slowing causes a decline in general prices as consumers wait for discounting and this dynamic is deflation by definition.
I’ve been in the deflation camp for at least two years for one very simple reason: U.S. home prices have been on the decline since the third quarter of 2006. Put otherwise, the asset class at the eye of the financial crisis has been deflating for four years now.
And while it takes years for such a shift to drift into the everyday economy, I believe those signs are apparent today as slow-motion deflation is turning into real-time deflation.
In fact, I strongly believe that a closer look at much of the evidence clearly makes the case for deflation.
Consumer Price Index
The long-term trend in consumer prices is up. However, the near-term trend is mixed with the Consumer Price Index down today from where it was in the summer of 2008 as shown below (click to enlarge).
While the primary and upward trend of consumer pricing should remain in effect, the possibility of an intervening near-term trend needs to be considered as it seems that businesses are continuing to discount goods to entice consumers to spend. For interestingly, and despite an overall decline in consumer confidence over the same time period, consumer spending has mainly recovered from the “abyss” of late 2008 and early 2009.
However, if much of that recovery is a result of discounting and the trend of discounting continues, it is likely to cause the CPI to remain flat or move down slightly in the best-case scenario. Also possible is that this current discounting turns into deep discounting, or worse yet, consumer spending slows in the face of deep discounting causing it to turn into distressed discounting.
While not certain to occur, deep discounting or distressed discounting will result in a decline in the Consumer Price Index and this will be very clear proof of deflation.
The prices for copper, steel, lumber, and some other hard commodities have been off between 10% and 35% since April depending on the commodity. While it is impossible to know whether this near-term trend in commodity pricing will remain in place, there are two charts that may suggest a continued decline:
First, the 5-year chart of copper shows a trough of sorts that is significantly below current pricing per pound and suggests a downward pull. If the fundamentals move to meet this suggested support level, such a decline would reinforce the fears of a slowdown in global growth and feed a continued decline in commodity pricing.
Second, those fears are further supported by a sharp decline in the Baltic Dry Index which tracks global shipping rates of dry bulk cargoes. While this drop is dwarfed by the one made between 2008 and 2009, it may suggest a global slowdown in demand and gives us reason to believe that commodity prices could continue to decline.
In an “unusually uncertain” environment, it would only be a matter of time before a continued decline in commodity prices would trickle into the Consumer Price Index and cause it to decline too.
Housing and Bank Lending
According to the highly esteemed S&P/Case-Shiller National Home Price Index, home prices are down 31% from peak prices in Q2:06.
This is a rather dramatic decline and it cannot be overlooked in considering the overall case for deflation.
First, it seems likely that a continued decline in value in the largest investment for most Americans, or their homes, will cause consumers to continue to wait for discounts at the very least but perhaps slow their spending all together. Either will show up as a decline in the Consumer Price Index.
Second, and more importantly, the deflation that has occurred in housing has had the unfortunate effect of causing bank lending to slow.
This has happened because the physical assets of houses exist simultaneously in the paper assets of mortgages. In turn, many of these mortgages are pooled together in mortgage-backed securities (“MBS”) which are then sold to investors.
When home prices started to decline in mid-2006, this decline brought the paper world down with it as mortgages started to go bad and especially those of the sub-prime or riskier variety. As a result, banks were left with the decaying mess made of the bad mortgages that were not pooled plus the rot of those pooled into the “toxic assets”.
The only response available to most banks in this situation was to write down or write off both the bad mortgages and the “toxic assets”. The initial net result of this response was constrained capital and a shift toward safety.
In the real world, this shift has manifested itself with banks choosing to lend to the U.S. government in the form of buying Treasurys with the low-cost of capital supplied by the Fed rather than lending to businesses and consumers.
Unfortunately, a decline in bank lending will lead to deflation as dried-up credit puts downward pressure on growth, demand, and, ultimately, pricing.
Back in March, I wrote about how the Fed was caught between slack and M2.
In other words, the Fed’s monetary hands were bound between the economic slack born of the recession and the money it had pumped into the system in 2008 and 2009 to keep it operable.
While monetarists were expecting the Fed to raise rates in order to prevent the increased liquidity from blossoming into inflation, this was not an option in the face of a fragile economy that needed the continued accommodation of ultra-low rates to keep the system functioning.
Simultaneously, the demand for cash by banks, companies, and individuals increased due to the uncertainty created by the crisis.
The result was a steep decline in the velocity of money due largely to the aforementioned decline in bank lending.
In other words, money is moving through the system slowly despite an ample supply of it because the bulk of it is being held by banks.
Until this money starts to move into the real economy, it will not and cannot cause inflation. However, as has been mentioned, it will lead to deflation as demand drops from credit-deprived companies and consumers, causing prices across the supply chain to decline.
At the risk of being repetitive: if banks do not start lending, deflation is a certain result.
Putting It All Together
There is one gauge of economic activity that does not support deflation at this moment: consumer spending.
Despite the black hole of late 2008 and early 2009 in consumer spending, recent figures, while tepid are mainly improved from that time period. If consumers continue to spend as they have been spending over the last 12 months, it seems likely that level consumer pricing will remain in effect unless, of course, it is maintained by the discounting previously discussed.
However, if the financial markets continue to gyrate, the housing market weakens, and the employment situation stays the same or worsens, there is reason to believe consumers may react as they did in the fall of 2008 when spending fell off a cliff. In other words, if the economic recovery falters, the risk of deflation increases dramatically.
In addition, and perhaps ironically, the world’s 30-year borrowing binge may, itself, promote deflation. As consumers and companies continue to pay down their debts, consumer prices could fall on potentially curbed spending. In turn, falling prices would cause economic growth to spiral down too. Unfortunately, this is similar to what happened here in the United States in the 1930s.
The ultimate sign of deflation, however, will be when it hits incomes. When people literally have less money in their pockets to spend, consumer prices will falter. Declining incomes will also make it harder for consumers to pay down their debts and will put further pressure on the housing and credit markets.
And for those monetarists who measure deflation, or inflation, by the federal funds rate, not only did the Fed recently comment for the first time that “underlying inflation has trended lower” but with the key rate near zero in reality and well below zero in theory, there is no arguing that inflation – hyperinflation – is tomorrow’s problem while deflation is today’s worrisome reality.
Disclosure: No positions
Disclosure: No positions