The Fed is Deflating: 10 Reasons Why

The collapse of U.S. housing is an effect that far outweighs the rise in oil prices. It's $1-2 trillion in final losses, and probably $2-3 trillion in credit contraction over the next 3-5 years as old loans fail, cannot be refinanced, and only a fraction succeed. Total spending (dollars x volume) has fallen and is falling. The results have not yet been fully felt, though the final result does depend on the size of the bailout package.

The basic speculative sequence has also been missed, as many analysts assume that the short-term price effects of a deflationary policy is actually an acceleration of inflationary pressure. But that is unlikely because the sequence will probably play out differently. For example:

• Interest rates too low in 2003-2004
• Higher supply of dollars and higher imports
• Dollar continues depreciating
• Fed raises interest rates
• Real estate market tops in mid 2005
• Domestic credit crisis in real estate financing starting in August of 2007
• Dollar continues to fall
• Fed cannot extinguish excess dollars (it would make the crisis worse) and cannot expand dollars (to offset deflation) as it may severely impact the market for U.S. treasuries ... so it essentially freezes the monetary base and "follows the market down" (we're here now)
• Lower interest rates and rising prices spur inflationists to declare victory (perhaps they are right, but isn't it premature?)
• Deflationary effects begin to overcome the initial inflationary effects perhaps late in 2008 or in 2009, although oil and other goods remain buoyant (supply / demand).
• 1 trillion in losses and 2-3 trillion in credit disappears, the net effect being several hundred billion subtracted out of GDP (about 2%-4% lost). The knock-on effects are larger than any correction since the great depression. Interest rates remain stubbornly high as risk aversion continues. Supply/Demand issues dominate in mortgage banking with "too many banks" being propped up for fear of a cascade of losses (like Countrywide).
• The near future coincides with extremes in Euro valuation against the dollar ... which will likely reverse, until both currencies see themselves in trouble against the Yuan.
• The Euro is given second thought as China will roughly equal U.S. GDP in 2011 (or near there) and their growth prospects, with some corrections, looks huge with the size of their population and available capital outbuild. Per capita GDP won't hit the U.S. level until an estimated 2040. Imagine the size...

The last few were speculation of course.

Fallacy 1 - There are different ways to measure money.

Not true. There are different ways to measure credit ... but not money. Credit is confused with money so frequently it is useful to point out the distinction. Money is the enforceable legal convention used for ultimate settlement - paper dollars or electronic cash reserves at the Fed. Only those items are ultimately used to clear settlements.

Fallacy 2 - Deposits are money.

Not true. They are credit offered to the bank. Credit is any transaction where one economic actor is obligated to pay another economic actor money at a later time. Credit is not money, but substitutes for money during good times. U.S. treasuries are not money, but they are turned into money when the Fed buys them or allows them to be discounted at their window.

Fallacy 2.5 - Banks create money.

Not true. Banks create credit. Even in history, banks could not create the means of final settlement as the market regarded only one or two goods as ultimate settlement. Ultimate settlement could be invoked at any time "on demand" by insisting on payment in gold or silver. Today, money - the means of settlement - is created only by the Federal Reserve. The U.S. Treasury creates physical cash and sends it to the Fed. The Fed replaces old currency and monetizes U.S. treasuries into new cash depending on it's policy.

Fallacy 3 - Oil and food items rising in price demonstrate a policy of price inflation.

Not true. If gas goes up, an economic actor will have to spend less on something else. An economic actor can only spend more on both if they have more income or more credit. There is no such thing as inflation without an increase in spending power - money or credit - to go with it. A drop in the demand to hold money is reflected in rising incomes with the same amount of spending power (money plus credit), which the central bank should offset with higher interest rates.

Fallacy 4 - Rising prices indicate inflationary policy and falling prices indicate deflationary policy.

Not true. Rising prices or falling prices do not indicate policy by themselves but indicate changes in relative demand for a good. Only when total spending (dollars x volume) expands beyond the ability of future supply does the process of price inflation begin. Without showing that total credit or money is rising faster than overall supply, no price increase can be argued to occur from monetary expansion, hence policy cannot be argued to be "inflationary" unless all factors are considered.

Fallacy 4.5 - Indexes show inflation or deflation.

Not True. Indexes tend to underestimate (frequently) and overestimate (rare) price inflation depending on the particular circumstance and indexes lag the events that cause price inflation or deflation confusing a lot of analysts. Indexes didn't include housing price inflation and don't include the housing price deflation, but they are including the rise in rental costs as many former homeowners become renters.

Fallacy 5 - The Fed can (or will or must) "bail us out".

Not true. The Fed has diminished their ability to "inflate" because they operate on a base of roughly 900 billion in base money - and that's after nearly 100 years in operation (and 95% drop in the value of the dollar despite major growth). There is no practical way to monetize a trillion-dollar mortgage-banking accident into cash without completely destroying the currency, ruining the market for U.S. treasuries, and effectively shutting down the Federal Reserve. The only option is to "borrow" our way out. Under current circumstances, to do so without price inflation will require extinguishing a multiple of that purchasing power in the private market to offset the public debt.

If investors sense hyperinflation, they will front-run the Fed even if the Fed isn't yet inflating - which appears to be happening to some degree now. The Fed might need to go far into deflationary territory before a scared market is satisfied with the soundness of the dollar. Rather than analysts arguing for a persisent policy of excess monetary expansion, it is far more likely the Fed will oscillate policy from fast to slow, as then they have a more sustainable market for treasuries by pushing participants to extremes on in the market, effectively forcing a "bust" and creating demand for currency.

Is the Fed deflating now?

Most likely. Total credit is and will continue (without intervention) to fall strongly while the Fed holds base money expansion nearly flat. If those circumstances hold, policy is deflationary no matter what certain classes of prices do.

Ironically, if the Fed reverses soon enough, price deflation may not be evident across broad groups of goods that are now rising and the inflationists would appear right even though they are currently incorrect.

For now, the current credit contraction may be the worst since the great depression. The near collapse of U.S. housing is an effect that far outweighs the rise in oil prices (the banking system will probably register between 1 and 2 trillion in final losses, and probably 2-3 trillion in credit contraction over the next 3-5 years as old loans fail, cannot be refinanced, and only a fraction succeed). Already, defaulted loans are near 650 billion. Price deflation - should it occur - will be baked in when average goods (those that are not busted like housing or going up fast like oil) register price declines.

Only in the case where the losses are not taken (a bailout leaving a large part of the spending power in existence) AND the Fed complies by running looser money will that solidify the past monetary expansion and lead to future (very high) price inflation.

Fallacy 6 - "Sensitive" prices (gold, commodities) indicate the Fed is inflating.

Not true. Prices are rising from past policy, not current policy ... Gold is a good indicator of expected future price inflation or deflation, but the price of gold is only partly dependent on current monetary policy because gold also responds to changes in the supply of goods and the demand for currency for settlement.

For example: If the central bank for 10 years provided the basis for credit expansion which was used to build hundreds of skyscrapers neglecting the production of an essential good like oil - then oil prices are going way up. Credit has functioned to expand the economic outbuild only to emerge with severe supply constraints. Gold begins to rise in anticipation of price inflation.

But a problem created by 10 years of neglect isn't likely to be solved by 1 year of tight money. So the Fed must collapse demand across the board (all sorts of businesses unrelated to the booming industry of skyscrapers) to bring oil prices in line. The LAST prices to give will be oil and oil substitutes - whose production has been neglected.

Since the last prices to respond are those that are rising the strongest, to immediately halt those prices from rising would take a deflationary policy with it's own set of costs after the economy had to bear the costs of inflation. The best course of action would be to stop monetary expansion which means - to the extent capable - slow the expansion of money and credit by watching the balance sheets of the banks carefully, and let the economy adjust. Over time price increases will moderate, but will remain at a higher overall level.

The Fed will need to follow the sequence: tighten (break the bubble), loosen (offset the deflationary contraction), then tighten (maintain tighter money during recovery to stop residual inflationary pressure).

• It is not enough to collapse a specific industry (like mortgage banking).
• Many related prices (because of supply constraints from prior inflation) can rise in a deflation.
• Which is what is happening to mortgage banking (formerly inflated and now busted) and oil, commodities, and energy.

The fiscal authorities could help by reducing government spending (which consumes and uses up precious resources for little benefit) and cutting taxes allowing the market to restructure: not by continuing government spending while reducing taxes.

Fallacy 7 - The Fed does not have a good reason to deflate.

Not true. The Fed is the world's largest market maker. Their #1 no-holds-barred, essential-to-survival task is to make a market in U.S. treasuries using the supply of dollar money and dollar credit to the world. Until that reality changes, they will do whatever it takes to keep the game running as long as they can. That doesn't mean the Fed won't figure some other way to get markets to take treasuries, just that under certain conditions, deflationary policy is a risk (note the early '80s).

It might prove useful to consider the global economic situation as "currency wars" where international finance either wants the U.S. dollar to remain dominant or plan to shift to another currency at some time in the future. Large players push markets to extremes so they can put on and unload positions. The central banks are market makers and are also influenced or controlled by the largest market makers in the world of finance.

Fallacy 8 - The Fed is printing money hand over fist.

Not True. The Fed **IS** deflating.

Don't believe me? Check out the stats on the base money here... it is rising glacially during the worst credit implosion since the Great Depression (note the much higher numbers in prior years). Note the latest graph for ABX HE AAA 07 indexes. And M1 going flat (note also how it went flat at almost precisely the breakdown in the housing market ...and ditto for the year 2000 stock market break).

In a nutshell:

• Money is not credit
• Inflation is not rising prices. Deflation is not falling prices. Both are complex and a distinction between monetary expansion, price inflation, monetary contraction, and price deflation needs to be made.
• Inflation and deflation are from an increase or decrease in total spending (dollars x volume) compared to future supply of goods and services (a good reason we should have private money as entrepreneurs are motivated to correctly determine the future).
• Deflation and inflation are tied to how credit substitutes for money. This complex relationship has to be analyzed carefully for conclusions to be correct.
• PRICE inflation is influenced by former policy which also affected the restricted supply of the goods that are now rising.
• It takes time for equilibrium to be reached even when policy freezes.
• During a significant contraction, holding base money flat is a policy of deflation.

Fallacy 9 - The Fed will pursue a continuous policy of inflation or deflation.

Probably not true. The Fed will OSCILLATE policy because they make errors, and because that provides greater ability to push credit into the system. Credit stimulates trade, which increases deposits, which provides the purchasing power for the private markets to buy U.S. treasuries as collateral and as protection against the bust. Investment policy: It is prudent to hold inflation hedges and hold deflation hedges. Be aware of the monetary factors which will affect your personal ability to generate income.

Fallacy 10 - There is a sure-fire inflation or deflation argument.

Not true. The situation is more complex. The examples given by inflationists or deflationists can be reversed. For example: If the government runs a deficit to prop up real estate it's not necessarily inflationary because the Fed has to make a market for more government bonds. If they can do so only by increasing treasury rates higher than they otherwise would have been, that may cause deflationary effects. Catch 22. Inversely, if people don't pay their debts and a large part of the banking system goes down, existing dollar positions may be sold in a panic against real goods, causing a re-evaluation of the position of the dollar as a reserve currency, which feeds on itself, resetting the dollar at a far lower value. With such a large change in the demand for dollars, a deflationary (credit) "inflation" (prices) occurs. The results are ambiguous because it depends on what an economic actor believes other people will do ... and then the market promptly does the reverse because too many economic actors are on the same side of the market. Whether we have inflation or deflation depends very much on market psychology in regards to the dollar in the future - a very difficult issue to pin down. There is one argument you should consider: if the interbank settlement system goes down (like would happen in a derivatives crisis) the Fed cannot operate and no one will take dollars for trade for fear of the Fed providing excess money. The dollar becomes worthless and all assets are lost. Is that inflation or deflation? Depends on your point of view.

Hopefully that never happens and we get better policy in the future - perhaps a private market in money. Until then, policy has, and most likely will, continue to oscillate.

Comments

[westwest888]

This is perhaps the best article I've read on SeekingAlpha in the last year. Thank you.

[damienh]

You mention just about M1 supply, How about M3 supply which is not published?

[ItsJustMe]

"The Euro is given second thought as China will roughly equal U.S. GDP in 2011 (or near there)..."

Jim, you're losing me here. Just off the top of my head, I believe that China's GDP was roughly 3 trillion last year and growing at 11% annually compared to the US's 12 trillion which is growing at 3% annually.

Yet, you're saying China's GDP will catch the US in 3 years? Based on my math, even if the US economy stops growing completely, it would still take China 13 years to catch our economy at their present rate of growth.

Most economists are predicting 30 to 40 years for China to catch up because the US isn't going to stop growing and like Japan and Korea learned, 11% growth isn't sustainable over long periods of time - especially when you're dealing with several hundred million uneducated peasants that China in particular will have to feed.

I still remember the 1980's when everyone (including the Japanese) were predicting that Japan's economy would overtake the US by the turn of the century. Japan doesn't have near the intrinsic problems the Chinese have and we're still waiting on that prediction...

[James Seaberg]

Jim, I commend you for your great analysis of our present situation with your recent three articles. It is amazing how many comments the article from the 10th of March 2008 has elicited by “flow5”. “flow5” mentioned Keyenes and Friedmann which both are wrong in mayor parts of their theories. I would like to submit that the study of Ludwig von Mises and his great work Human Action and related articles would solve many of our present-day controversies. This book can even be downloaded free of any charge courtesy of mises.org . If there are readers who are hurt by this recession and which are not economists, they probably would enjoy the very readable book The Creature from Jekyll Island: A Second Look at the Federal Reserve by G. Edward Griffin.

[StateofConfusion]

Perhaps its just me but like many articles I read, the end result is no real direction. So we will maybe have inflation or deflation or both. Do I buy more gold stocks? Is my money safe in a bank account? Will the stock market continue to go up or crash? If there will be price deflation, I want more cash. Mr. Bradley seems to say that with reduced credit and plenty of goods, that is what will happen (except for oil and food). While the author explains many things about credit and money I am again left in a state of confusion.

[adan]

great article; would like to add my current favorite quote (from Thomas Jefferson):

"If the American people ever allow private banks to control the issuance of their currency, first by inflation and then by deflation, the banks and corporations that will grow up around them will deprive the people of all their property until their children will wake up homeless on the continent their fathers conquered."

i think my only hope right now is that we, the american people, will be brought in to help win the "currency wars" mentioned above, and become allied with those keeping the currency alive; just a hope though :-)

[flow5]

How does $5.00 a loaf bread fit in?

[CharcotEpigone]

When incomes drop and prices rise, consumption as a whole may decrease -- thus leading to drops in prices of commodities that only have an internal American market. If that is true, baseball park tickets should be less expensive. So, if that is true, this is a good time to go on the Green Bay Packers ticket/owner list.

[Big Jim Slade]

"There is no practical way to monetize a trillion-dollar mortgage-banking accident into cash without completely destroying the currency, ruining the market for U.S. treasuries, and effectively shutting down the Federal Reserve."

This is the core of the deflationist argument and here is why it is wrong: Just because the solution elucidated above is neither practical nor logical, and will be an utter failure, doesn't mean they won't actually try it. And in fact they HAVE to try it because they have no other alternatives given the tools they have at their disposal, and the environment that they are working in.

Jim, you didn't think through the obvious conclusion that in our system, money = credit. THERE IS NO REAL MONEY IN TODAY'S ECONOMIC SYSTEM. Real money has all three of the following properties:

1. store of value
2. medium of exchange
3. unit of account

fiat money only fulfills conditions (2) and (3). I postulate that a full-blown deflation cannot happen when what is commonly used as money, is not in fact a store of value.

We will see deflation in all leveraged and paper assets; we will see inflation in all hard assets (i.e. anything that is a material store of value).

[syruppy]

I am not certain we should be calling what has happened in housing a "bubble." Corruption, yes; bubble ... no!

Unlike the Dutch tulip mania of 1634-37 that drove prices for a substantially similar and ephemeral commodity to unsustainable heights, housing was not a bubble begging to burst; maybe just deflate a wee bit--for now--before getting a second wind.

Similarly, the dot-com bubble smelled a lot like the ephemeral tulip bulb of Dutch-daze when it burst in 1999-2000.

Homes, however, offer obvious tangible and psychic value. I think everyone probably knows that, given a burgeoning and dynamic society (full employment, increased productivity, a growing economy), the unsustainable housing prices of yesterday probably will seem a lot less heady in a few to perhaps a dozen years down the road.

What is missing from the housing debacle--which is more a story of too much, too quick, instead of too much ever--is a villain. We've got the usual credit criminals, facilitators and enablers that are always more than happy to feed on a something-for-nothing society, whenever the opportunity arises. They will serve to time and the politicians are actually lining up to reward these dysfunctional societal behaviors, even as they roast all of our gooses.

There is no Charles Keating or Michael Miliken to whip like a rented mule, to throw in jail for their perfidy, to crucify for the sins of a something-for-nothing society that always seems to be in the market for new morals and ethics at cheap prices.

It is time for business investment to keep the economic wheels of fortune turning. We can expect no help from government unless it wishes to lower taxes, create ITCs, de-federalize the economy, and deflate government bureaucracy.

For people with more than ethics in their pockets, it's time to smell the roses: cash is dead, long live the cash!

[7c-ranch]

Excellent-very thoughtful and thought provoking.

[punk_ash]

This is the single most intriguing article on theoretical economics I have read in my life, a PhD material. I salute you for your insight. What we have on TV and online are a lot of pseudo economists who themselves do not understand these topics well, great job.

[proseadvocate]

I find it rather naive to believe that we can ever again see genuine price deflation without a gold standard and a guarantee conversion price for every dollar printed or loaned. It is true that no other country (maybe Swiss?) have a monetary system even close to that but then we must rely on supply and demand. Why would anybody want to hold dollars except to buy our stuff. Nobody wants it except our grain, a commodity that hardly equates to added value profits. We have turned into a third world supplier of commodities which are not dear like gold or oil. The pendulum between greed and fear has taken us to a point in time where a $3 Trillion cost of a foreign war of aggression (which was supposed to give us cheap oil) has demonstrated the hight of hubris and lies that have become the hallmark of America thoughout the world.

[Stanley]

Jim, do you think the Fed is actively deflating or is it just failing at trying to inflate with the tools it has. The Fed can only provide cheap loans to banks. It can't make banks lend out the cheap money nor can it make borrowers want to borrow it. Banks want to lend less and at a higher margin because asset prices are falling (like houses) and banks need to make only higher quality loans if they want to survive. Borrowers are also less likely to borrow for the purchase of overpriced houses that will likely continue to decline in value and will probably borrow less on other higher priced consumer goods like cars and high end electronics if their home equity/net worth is erroding away.

[Hank Jestor]

Stanley,

You are correct. The Fed is attempting to Inflate, but the money is being blocked by the banks and being shifted to cover their losses.
The Fed is following the correct policy, its just to bad its the wrong country. They obviously have an American-centric view of the world. Instead of looking at how we could have avoided the 1930's depression from a U.S. perspective they should be looking at what the German and British could have done to prevent the depression in the thirties.
The Chinese model the role of the U.S. in the 1920's. They have the savings accounts to enable the inflationary policy that is needed to stimulate our economy.
To prevent a total worldwide collapse the Chinese should:
1. Open their markets to U.S. goods and encourage their purchase with tax breaks. This will cause the creation of jobs in the U.S. and provide a stable base of manufacturing in the U.S.

2. Lower interest rates by 2 points in China.
3. Re-peg their currency to the U.S. dollar.
4. Increase export taxes on Chinese goods.

This will cause a lot of pain in China and I doubt if they will see the long term benefits of having a stable U.S. economy. Their culture is not the same as in the U.S. No other country will ever be able to replace U.S. consumption and our ability to drive the world economy. Its a very cultural phenomenon.

I don't see the Chinese doing this at this point. They will continue down the road the U.S. went down in the late twenties.

[Hank Jestor]

Follow-up Predictions:
The Chinese will continue fighting inflation and not ease their trade barriers. This will cause a 1920's U.S. style depression in China. The U.S. will suffer from a short depression and mirror the German model of 1930's economic growth.(probably political changes ahead)
History always repeats itself and the fundamental issue is not sub-prime loans. The issue is that what people bought with their free cash was all Chinese, all the time. We have gutted the base of the economy with the trade deficit. To recover we will have to rebuild that base.
What can the U.S. do? Trade barriers. We need to force people to choose only U.S. made products. This will re-establish our economic base.
Thats my 2 cents.

[Mark in SF]

This is a great article. I've been trying to explain to people why commodity prices increases, and the prices of items that are heavily dependent on commodities, does not constitute inflation - at least not the kind we associate with a y/y percentage like in the 70's. Also been trying to explain that the fed is NOT printing money (at least yet). I will refer them to this article, which does a better job of explaining than I've been able to do.

[Lucia]

So far this is the best artical I read that (in my opinion) really know what is going on. Thank you very much.

[JIMB]

Damienh - M3 is a broad credit measure with very little consistent connection to long term price inflation.

ItsJustMe - CIA stats put Chinese GDP at more than 7 Trillion on a PPP basis. I suspect the actual figures of Chinese vs. U.S. are closer than the official stats, especially since the U.S. has been fudging the CPI numbers for some time.

StateofConfusion - Keep a portion of assets in physical cash and physical gold. The point is whether we have inflation or deflation depends on a number of factors. The underlying secular trend is inflationary, while periodic cycles speed up and slow down that trend. It can switch violently if the Fed is unsuccessful.

Big Jim Slade - I concur with your sentiment. However, its very unlikely the losses will be monetized except over a long period of time. If the markets thought the losses would be quickly monetized, it would immediately bring on hyperinflation (dumping the dollar) and the only way the Fed would "remain in business" would be to vigorously deflate credit and money so substantially that a good portion of the banking system would go down. Only the most well capitalized companies would survive and they would then be a buy. The market can ask for and get deflation if the market overcomes the central banks attempted support of the dollar.

The whipsaw would be unbelievable (inflation to deflation and vice versa). I don't think anyone really can reliably make out on that volatility except to hold both sides of the fence: cash and gold.

Stanley - The Fed is actively deflating at the same time trying to prevent the settlement system from going under.

MarkInSF - Commodity prices are price inflation from prior credit and money inflation, not present credit and money inflation. The Fed will likely reverse course and begin inflating at some point in the future, but it is not doing so yet.

Thank you for the opportunity, everyone. Good luck in this investment climate.

[jcrash]

You can debate the technical definition of inflation and perhaps that is what the world markets consider relevant; however, to John and Jane Doe living in Anywhere, USA, facing flat to 2 percent pay increases year over year and costs (fuel, housing, energy, food, education, healthcare) increasing at rates unseen before EVER (on the whole), your debate is pointless. They suffer from a lower and lower living standard and, assuming I understand what you say, that will continue without abatement for the foreseeable future.

Call it inflation, call it deflation...doesn't matter...they pay more for less.

[special1person]

First of all, this appears to be "spin" to support the FED's current policies of "stagflation".

I don't know if this is true or not, but...

"Homer Hoyt did research that indicates a country cannot go into recession unless there has been a real estate bubble."
www.foldvary.net/works/rebc.html

Residential housing values are deflating now, because they inflated much faster than wages did from 1997-2006.


"Fallacy 8 - The Fed is printing money hand over fist."

Ha, ha. M3 has been increasing at 15% a year, under King George II.

That's not a fact--it's speculation--because King George wants it that way.

Anyone that thinks the money supply has been decreasing during the past 7 years has not been looking at the facts.

[Mish]

Excellent Article
Mish

[JIMB]

special1person - It's important to distinguish between credit (M3 or L) and money. Money hasn't expanded at all to keep up with leverage. In fact, leverage is vaulting higher because equity is shrinking (asset losses) while investment houses have been forced to hold paper they don't normally.

While I can't say what the Fed or the international dollar market will do, I can definitively say (if the Fed's balance sheet is to be believed) what the Fed has done in the last 2 years.

Now that the Fed has opened up their discount window to Investment banking houses, failures may slow down, and that can be inflationary if liquidity expansion increases substantially while supply constraints still exist ... but the effects now will be felt down the road, not immediately. Past policy is having effects now (witness the sudden collapse of Bear Stearns and failure of 240 mortgage banking companies).

Even with significant expansion of liquidity and price-volume effects, continued losses will likely pressure and may still take down more major players. That can, by the way, still happen in inflation. We'll see.

[BlueLou]

This article is poorly written since the author asserts that the Fed is pursuing a deflationary monetary policy while offering logic that contradicts this assertion.

The author states the following: "Without showing that total credit or money is rising faster than overall supply, no price increase can be argued to occur from monetary expansion" Assuming the author meant 'money demand' and not 'supply', the converse should also hold true. That is, a price decrease cannot have occured from a decrease in money supply unless this decrease has been faster than the decrease in money demand.

Note that this line of reasoning is consistent with the identity velocity*money supply = real GDP *GDP deflator.

Also note that both Nominal GDP and Monetary Base have a 10-year annualized growth rate of 5.2% implying that money supply growth has tracked nominal GDP growth.

That the monetary base has been flat for the past few quarters is likely due to the cyclical decline in Real GDP growth and a contemporaneous decrease in money demand and not due to a deflationary monetary policy. At best, given a slowing economy, a flat monetary base can be said to be "non-inflationary", but certainly not "deflationary".

[Agenda42]

Keep writing, this article is good food for thought and offers up reasonable evidence for open examination.

[DrMarcusAurelius]

This is an excellent article with much to think about. However, I can't resist a professorial quibble: if you call a proposition a "fallacy" then don't tell your reader that it is "not true" since doing so is either redundant or a double negative.

[bmayer]

BlueLou, you make a good point, although it is unfair to the author to say that the article is "poorly written". On the contrary it is very well written, regardless of any perceived conceptual inconsistencies or disagreements with its conclusions. For that Mr. Bradley deserves kudos.

But I can agree that the observable flat growth of the monetary base over the most recent period may not be a function of Fed *policy*, but a function of a relative decrease in global demand in USD (due to whatever reasons that I'll put aside for the moment) that the Fed has made it a "policy" to conform to and not fight against, as this fall in demand itself is a present function of the previous expansion of the monetary base under Greenspan, possible only so long as demand for USD remained strong.

IOW, the Fed - far from being the all powerful Oz that especially "permanent inflationists" like to portray it in order to bolster their argument - is just another government institution that just may be constrained to react to events that are fundamentally beyond its control. And, to arrive at the "moral" of the story, this is precisely what is at stake in trying to gauge the extent of the irresponsibility of the Greenspan Fed in having created conditions of total supply of USD money + credit that may well be beyond the control of any Fed at present.

[Muddling Investor]

Well, everything is true. Almost. There are two problems with this article:
1. Fed was asleep and just woke up. They found out that credit is in crunch and trying to fix this problem using all possible ways.
2. Fed may want to inflate right now, but money supply contracting faster than Fed is able to push out new money. The biggest danger right now is liquidity crisis: zero interest rate + money contraction, Japanese style. In other words, deflationary spiral. Bernanke wrote a book on Japanese Great Depression, he would love to inflate the way out of crisis now, the problem is: does he have enough ammunition?

[iTod]

Jim,

would having mortgage work as inflation hedge instead of gold? Since mortgage will be paid off over time with less valuable currency... obviously interest eats away at it a bit but Gold is so messy to buy, sell and hold.

[jankynoname]

BlueLou - I like your reasoning.

M * V = P * Y
money supply * velocity = price level * real GDP

this can be used to argue that increases in the overall price level are going to be more sensitive to high turnover assets then they are to longer duration assets. The author claims that the $2-3T that will disappear due to housing deflation will cause overall price deflation, be these are not assets that turnover with any regularity. The mortgages are packaged into very long-term debt securities, basically their velocity is tiny compared with currency, commodities, oil, etc. I don't think this will have any meaningful effect on price levels.

Then he says the fed is not following inflationary policy. This is total b.s. Every time the fed injects $200B (too many times to count now..) this translates to a $2T increase in the money supply (remember, the reserve requirement is only 10%). Yes, this $2T is in the form of "credit" not "cash" but it is still used to purchase assets and push asset prices up. The Bear Stearns injection alone will wash out most of the contraction in credit associated with home price declines.

The Fed is desperately trying to inflate right now (and trying to coax foreign central banks to do the same so the dollar doesn't weaken on a relative basis). Remember, that was Bernanke's ph.d thesis...

[Hank Jestor]

Deflating the currency is a good thing. I was a Ron Paul believer but now understand my folly.
The fundamental problem in the U.S. is they want less expensive goods from overseas in spite their face.
Like the Fed says, "there is no problem with a cheap dollar if you buy American products". What he is doing is shipping the pain overseas and bringing jobs back home. Will this work overnight? no. Will it hurt? yes.
Benefits:
Higher fuel cost will cause:
1. the needed investment into alternative fuels and lessen our dependency on Middle East Oil.
2. Slow consumption.
3. Bring jobs back to the U.S. since the cost of outsourcing will rise.

The Dollar only matters if you are buying cheap foreign products and anyone who thinks we don't buy enough cheap products from overseas is crazy.

[iThinkBig]

"1. the needed investment into alternative fuels and lessen our dependency on Middle East Oil."

Bingo. If this government were at all serious about avoiding a depression by 2010 we would be declaring the U.S. economy a disaster and through executive order de-regulate ALL forms of domestic drilling EVERYWHERE, along with de-regulating nuke plant build-out. In addition, Treasury should release $200 B into alternative energy (skip ethanol please!) and focus on biodeisel and coal liquification, solar. This would create millions of jobs and take the froth out of oil speculation. The real issue is we are a service economy. We don't make much the world needs anymore. Give the global consumer what it wants and needs to grow and we'll be fine. The trouble is, we'll likely not do the above mentioned until we are already in a depression.

[vaduz]

for me the end of the story is a much cheaper dollar.
thks for all the thoughts about false thinking

[syruppy]

I agree with jankynoname. When it comes to housing prices, while some on the margins have been caught up some inconvenience due to their own "irrational exuberance," mostly only some irrational expectations have really undergone some serious revaluation.

For example: Assume Buyer purchases a home in the 2000s for $550K, after house prices already have been rising steadily since 1996. At the time of the purchase, Buyer thinks, e.g., "I'm probably the last purchaser before house prices fall ... but, I need a house." House prices continue to rise and Buyer feels comfortable investing $150K in the house.

Buyer retires and wants to move, so the home is put on the market in 2007 for more than $1.7M. The market has changed and the home does not sell. Buyer continues to live in the home and lowers the price of the home to $1.5M in 2008, although that still is not low enough to attract a buyer in the housing market.

Question: Extrapolating the above $200K decrease in the listing price of the home to the entire market, have housing prices in the Buyer's region really suffered a serious deflation in value? Should the entire economy go into the tank because the irrational expectation "bubbles" of a relative few number of home-sellers have been pricked?

[BlueLou]

bmayer,
I like that phrase about the Fed being thought of as an "all powerful Oz". That is my problem with an article titled "The Fed is Deflating: 10 Reasons Why". Again, the author did not present a single correct reason as to why the Fed is presumed to be deflating.

Here are the relevant facts:
1) There is a banking crisis. The commerical and investment banks have taken significant write downs of their capital bases and this has impacted the price and terms of credit, particularly to other banks. A simple analogy would be to think of what happens to the price of homeowners' insurance in Florida after a very expensive hurricane loss.

2) The Fed can't influence the willingness of banks to extend credit directly but what it can do is to is take measures to assure that they have sufficient liquidity. Also, the Fed and SEC can take measures to relax regulatory capital requirements (i.e, solvency) by taking weaker forms of collateral or encouraging commercial banks to recapitalize investment banks (e.g., Citigroup ->SmithBarney, JPMChase ->Bear).

3) Note that 1) and 2) have nothing to do with the Fed pursing a deflationary policy and everything to do with the the efforts of the Fed and other regulatory bodies to improve the liquidity and solvency of the banking system.

[VennData]

When the Fed releases $200B of bonds for collateral, that collateral must go out an get cash FIRST before buying assets, so there’s is no net gain loss of currency (M1) since the banks must get the cash by exchanging those new bonds for cash SOMEWHERE ELSE. The Author is right, Banks don't create cash…

…and the perma-inflationists are wrong. M3 doesn't correlate that’s why the Fed dropped it. M3 is useful only to people trying to market gold to you and their big gamble junior mining stocks.

If the Perma inflationists were right - if M3 was "the tell" - gold would be much higher after all these years of M3 growth, that's why they've created the non-falsifiable “Central Bank conspiracy" to delude the people who buy their gold and gold stocks.

If you want gold, buy GLD. GLD will end their marketing routine since it's cheaper, easier. Bt I’m sorry to say will not outperform in the long haul… Unless… you want to track the future gold price? Look at the trend in Indian weddings, not M3.

Inflation is always and everywhere a fiscal problem (with the help of the big market maker, the Fed, swapping treasuries for cash.) Sure those rare Zimbabwes and 1930's Germany printed tons of money, but that's 1,000% increases of M1, not 3% increases in M1.

[clitosil]

What ever you do, do NOT pay any attention to the man behind the curtain! Nothing to see here, move along now...

Left is right, up is down, inflation is deflation, good is bad.... As long as we don't expand the supply of "cash" we can borrow our way out of any predicament.

[smart money]

This has to be the best article on Alpha yet. What we do know is that commodities are increasing in price. If it is being caused be a deflating dollar or a inflation speculation we should still do well making foreign investments and investing in gold. Oil will do well for some time before the economy tanks so badly that our oil consumption declines.

[nyinvestingmeetup]

This is quite possibly the stupidest thing I've ever read online. Deflation as described in this article is actually a key component of hyperinfllation, which takes places when the monetary base doesn't expand nearly as fast as prices increases. In Weimar Germany, the monetary authorities and top economists constantly made the same argument made in this article, claiming deflation was really taking place just as inflation was beginning to skyrocket, just as is happening in the U.S right now. The fools that listened to such idiocy were wiped out.

[pseydocyst]

Sorry, but I just don't buy this.

Prices of gas, bills for tuition, everyday grocery
items keep going up, and you say the fed is
deflating. What does that mean? Just an abstraction?

[Bhakta]

Thanks for a very well written and thought out article. It is a bit over my head too, but I am trying to digest it. Personally, I cannot see the FED supporting deflation for long, and obviously they don't want rapid inflation either; they want equilibrium-stability, which is difficult to achieve when greed and fear, rather than common sense and ethics rule man's conscience.

[Matt Callow]

You are a wise man.

[smart money]

The people stating that this article are stupid do not understand that the author is just trying to get everyone to think. As I stated above do not worry if we are inflating or deflating both will happen many times over in order to fix this mess. Better yet take all the information given here and use it as ammo in order to make wise investments. What I am saying is don't go out and buy stock in companies that do not have a economic hedge against a falling dollar or rising prices, those will be first to fall. Buy what we should invest in are, precious metals and miners, oil drillers and services, foreign companies or US companies operating aross sea. The debate does not matter it's getting you to think that does!

[Hank Jestor]

Smart Money,
Right call for the next 2 months, wrong call long term. That would be the right call long term if you believe the decoupling myth. I would want to be in anything overseas once the U.S. consumer really starts to shutdown. China and India do not have stable governments and the sh*t will hit the fan once inflation raises its ugly head for real there. Already seeing it in Asia. Ninety percent of the people in those countries live at the poverty line and food shortages are occurring now.
The reason that the U.S. has always been able to pull itself out of economic hardship is the fact that we are geographically isolated and can produce food likes there is no tomorrow.
There are already reports of Chinese workers showing up for work and finding the factories closed.

[mickrussom]

M3b. You are trying to argue that money supply and credit are unrelated - this is garbage. Many empires with fiat currencies have died with inflation. The decline and schism of the Roman Empire was right around the time of mad inflation. Contract enforcement and strong money is what kept the British Empire so strong for so long, one of the few things they had a capital punishment for was counterfeiting.

The thing that kills me here is that the insinuation that the commodities prices in dollar terms are purely demand. No. The commodities prices in terms of other currencies/commodities has not risen as fast as in terms of dollars. The USA has:

- 9 trillion in debt
- 20 - 60 trillion in debt obligation (no one really knows)
- 850 billion trade deficit
- War in Iraq
- War in Afghanistan
- Bin Laden and Al-Qaeda alive
- Fomenting War with Iran
- 13.9 trillion M3b money supply, and expanding
- Investment banks defaulting on 30:1 obligation to assets, and then the Fed helping bail them out

How is it fair that dollar futures are going down, dollar in terms of gold and dollar in terms of commodities is fair to the saver? Fair to the responsible? Fair to the people on fixed incomes? Fair to those who have to burn shingles for heat in the Northeast?

Now it has a Fed which creates all the asset bubbles we have seen.

How Bad is the Commodities Price Index, the true measure of inflation?
Jan 10 2008
CPI = 254.2
media.economist.com/images/20080329/TAB3.gif

Sept 24 2005
CPI = 131.8
www.economist.com/images/20050924/TAB3.gif

This is so bad that the worlds most prolific investor, Warren Buffet (BRK.A BRK.B, of which I own some) cant even make money faster than the rate of commodities inflation. Even Warren talked on squawk box not long ago said the system is rigged to favor him, and the middle and upper middle class are getting screwed, and that bad employment data (which hadn’t come out at the time) would be not good news. He dislikes the banks and the hedge funds. Jim Rogers of Quantum Fund fame lashed out at the ridiculous fed policies. Who else has to say there are big problems with US money policy, and the US policy? Richest man in the world? One of the most prolific commodities traders ever? Who else? You are going against some pretty convincing self made men here with this deflation/demand stuff.

It was 100 in the year 2000. I don’t think any of our salaries have double to accommodate for this. This isn’t just inflation, its stagflation.

Let me leave us with the words of Andrew Jackson on central banks:

Andrew Jackson was the first President from west of the Appalachians. He was unique for the times in being elected by the voters, without the direct support of a recognized political organization. He vetoed the renewal of the charter for the Bank of the United States on July 10, 1832.

In 1835, President Andrew Jackson declared his disdain for the international bankers:

"Gentlemen, I have had men watching you for a long time and I am convinced that you have used the funds of the bank to speculate in the breadstuffs of the country. When you won, you divided the profits amongst you, and when you lost, you charged it to the bank. You tell me that if I take the deposits from the bank and annul its charter, I shall ruin ten thousand families. That may be true, gentlemen, but that is your sin! Should I let you go on, you will ruin fifty thousand families, and that would be my sin! You are a den of vipers and thieves. I intend to rout you out, and by the Eternal God, I will rout you out... If people only understood the rank injustice of the money and banking system, there would be a revolution by morning." ….

There followed an assassination attempt on President Jackson's life [by a double misfire of the assassin’s pistols prevented his death] soon thereafter. Jackson had told his vice president, Martin Van Buren, "The bank, Mr. Van Buren, is trying to kill me...."

[mickrussom]

@nyinvestingmeetup

Yes, this was a Wiemar mistake. Please also note that this allowed for the Fascist Nazis to waltz in. How did they nearly take over the world? A strong Reichmark.

[curious cat]

i had a young lady working for me at our medical office checkout window. she wanted to post a payment made with a money order as a "cash" payment. i told her that it was not cash, but a check. she and her friends all objected. they said, "it say's in their commercials and right here on the money order, 'good as cash'." well, how can you fault that logic?

our society believes that cash is as good as gold and that checks are as good as money. maybe they're all correct. nothing has value unless we believe in it. in fact, the first thing you learn in law school is that people make the law, everytime they make a decision. everytime a jury decides, they make law. the same can be said about money. everytime someone accepts it as a store of value, it has value. maybe that's where that "hot potato" game came from.

i wish i had the time or inclination to meditate over this article. i'll just accept that at some point, the potato will be too hot for me.

[Clearmind]

The best article I have read in a long time.

[pater suspriorum]

sorry, the Fed is decidedly NOT deflating. the narrow money gauges such as M1 and the monetary base are not growing due to sweeps - which have made it unnecessary for banks to keep reserves at the Fed for all the credit they have been creating. meanwhile, the credit creation is now a non-M1 component of M2, and if we look at MZM, it's growing at a parabolic rate of change. the Fed has put out over 50% of its balance sheet in dubious 'short term financing' via new special facilities, and you really believe it is 'deflating'? come on, you can't be serious.

[BlueLou]

pater suspriorum,
I couldn't agree with you more. The facts just do not support Bradley's claims and anyone with an iota of training in the subject would spot this immediately.

Truthfully, I haven't figured out whether this website is worth looking at yet. This is only the 2nd or 3rd article I'e read here. I see commentary from notables such as Bill Gross and others who appear to have strong credentials mixed in with people like this Bradley guy who is a "consultant" and obviously in over his head.

Any guidance as to who to read and who to avoid on this site b/f I delete this bookmark altogether?

-BlueLou

[JIMB]

pater - the most interesting thing is that your argument validates the reverse position. If it is true that the banking system net settles and can do with near zero liquidity, then it is true that leverage is off the chart. That makes liquidity more powerful, not less powerful -- and the analysis here more relevant. Good luck to you.

[BlueLou]

JIMB,
Why do you insist on using lingo which obfuscates your message? Your commentary does not appear to be grounded in either academia or institutional-grade research.

Please translate the following quote from your posting and how this supports your deflation argument: "If it is true that the banking system net settles and can do with near zero liquidity, then it is true that leverage is off the chart. That makes liquidity more powerful, not less powerful"

-BlueLou

[DenisL]

Wonderful article because it raises so many questions!
Thanks.
Just curious. Most of our arguments about money and the economy are based on the idea that M1 is conceptually like gold, and that the value of M1 is not subject to manipulation or fudging like CPI statistics.
Lately I have read that gold itself is subject to manipulation because there may not be the gold in the National vaults around the world that we are told. Everything including the old economists back in the 1800s is based on a mathematical model that is true only if it predicts the real world. My problem is: "The real world adapts to and thus changes all economic models. Is M1 really like gold? And is gold nowadays like gold was in the old days. This idea that the economic world changes when we think about it (I am thinking about what he is thinking about what everyone else is thinking everyone else is thinking, if you know what I mean) gives me a headache when trying to decide what to do economically to protect my family."