Why The Inflation - Deflation Debate Doesn't Matter

In this post I will discuss:

• Calculating the rate of "money printing" the Fed has been doing
• Why prices will still rise for some time
• Why the economy could get so much credit in the 1990s but still not show inflation
• Why inflation / deflation doesn't matter
• Possible investment policy "for the next 10 years"

A Recap of 5 Essentials

(1) Money is the item of ultimate settlement: cash and reserves at the Fed. Any promise to pay money in the future is credit. Deposits are credit. Checks are credit.

(2) The purpose of the Federal Reserve - from the point of view of banking interests - is to reduce the supply of settlement money and increase credit so economic transactions become mostly credit. This earns interest (and fees) for the banking system. It also increases leverage

(3) The purpose of the Federal Reserve - from the point of view of the U.S. Government - is to finance the government deficit. The central bank does this by controlling settlement money which allows credit expansion beyond what the market would allow, and by stimulating inflation which increases the cost for holding cash. Credit increases cause deposit increases. A large portion of bank deposits are used to buy U.S. Government Treasuries by the banking system. This process is global in scope.

If the Fed needs to hammer credit expansion down to make sure there's a market for treasuries, you can bet it will happen. Be aware that dramatic market moves bring benefits to the government. The great depression got the population off of gold and allowed far greater federal debt and banking credit compared to money.

(4) Monetary expansion, credit expansion, and price inflation are related, but any one can and does occur without the other. Monetary expansion permits credit expansion. Credit expansion influences price inflation.

Price inflation results from an increase in total spending (volume x prices) in greater amount that the economy can reliably sustain over time. The lag is sometimes short, sometimes long. It is usually in the range 6-18 months for the first effects on consumer prices. But sometimes the majority of the effect is not felt for years.

Significant changes in the economy's supply structure from excessive credit (which causes consumption of productive ability) can more permanently affect inflationary pressure.

A decent definition of monetary inflation is (a) an increase in money, which (b) allows for the clearing of excessive credit expansion, which (c) later causes price inflation.

(5) Usually the Fed manages by oscillating the rate of money expansion, which oscillates credit inflation and disinflation / deflation. During inflations, the Fed is orchestrating a disinflation / deflation and creating a resurgence of non-bank demand for treasuries. During deflations, the Fed is planning for inflation by stuffing currency into the economy, which later forms the basis of new credit and new deposits and thus purchases of Treasury debt by the banking system. Note the banking system (and credit intermediaries in general) do not care about inflation or deflation as much as the spread between the lending rate and the cost of funds. With leverage, the banking system can usually make far more than they lose from inflation or deflation.

All dollar holders (unless they've other side benefits) lose by dilution of dollar savings, which no longer has the same claim on goods. Anyone far away from the money spigot also loses, as their incomes change the slowest in response to changes in Fed policy.

The losses to society can be extreme. There is not just a transfer of wealth, there are also deadweight losses which occur because of capital consumption. A growing economy would also give wage earners a "slice" of a bigger pie as stable currency increases in value (a risk-free gain by deferring consumption in the form of gentle deflation) if it were not for substantial waves of money-substitutes (credit) which dilutes the value of labor in favor of powerful financial interests in concert with the government. In fairness, financial interests are frequently the target of government confiscation as well - so there's logic behind the game.

Calculating The Present Expansion of Money

Looking at the April 10th Fed's balance sheet here, you can see the line "Total Factors Supplying Reserve Funds" about midway down the first page. The figure is 918,827 for the week ended April 9, 2008 as an average of daily figures.

Now notice the change from week ended April 11, 2007 (about 1 year ago): 17,774. However we need one other adjustment. Reverse repos are the Fed's way of reducing day-to-day liquidity and that is money not available to the system. 17,774 - 3,475 = 14,299.

The other effects (like the change in the balances of the Treasury) very likely have minimal effect right now, so we're going to ignore those.

The total change in base money is therefore 14,299. Now we need our base figure in 2007 so we can calculate the percentage increase.

Base money supply this time in 2007 (weekly average) = 918,827 - 17,774 - positive change in reverse repos. Change in reverse repos = 3,475. 918,827 - 17,774 - 3,475 = 897,578.

Percent change = 14,299 / 897,578 = 1.5%

Despite the extension of temporary liquidity to investment banks, those increases have been taken out by other Fed actions.

(That means liquidity is still tight for any economic actor that is connected to, or is itself, an entity that isn't creating wealth, because those entities cannot self-fund).

Base money (cash and reserves) went up by 1.5% ... and this occurred during one of the stiffest ongoing credit corrections in 70 years. So monetary inflation is very tame in comparison to the "printing money" arguments. That's putting it nicely. In contrast, in 2003 and 2004 an investor can see rapid double digit growth in base money in some months.

Base money isn't the only factor. What about credit expansion? That's tame as well, as new credit isn't being created as fast as it's being destroyed.

Now the authorities may switch to an inflationary policy as the government gets even more involved in validating the credit structure. But the process right now isn't likely to happen fast enough, as millions of homeowners cannot get loans under new standards, even under FHA.

Even though the Fed has put the U.S. government on the hook by increasing their holdings of riskier securities, the net effect isn't (yet!) inflationary. But ....

The inflationists have not been right about policy since 2005. If they were right, oil would be $250 per barrel and 250 Mortgage banks would still exist ... Be very careful of assuming the Fed won't play hardball. Separate the facts of Fed policy from speculations on what they will do.

Prices Will Still Rise

An investor should be aware of the basic sequence of the cycle.

• Credit effects occur first
• then monetary validation (or denial) occurs
• then structural changes (supply) occur
• the Fed usually anticipates inflation and switches policy from monetary inflation to flat money growth
• and finally inflationary price changes occur.

Quite a few people mistake the end effects (price inflation) today for something that happened "yesterday" but the cause and effect can occur far from each other. In the U.S. significant structural effects have gradually gotten worse over the last 20 years, not just over the last five years.

In other words, not repairing the roof on a rental can go for some time before suddenly the owners are forced to sell assets and buy roofing. Over that time, the owners may appear very profitable. If the owner sells, the buyer of the house should realize how much "deferred maintenance" will cost. In my view, the U.S. has a lot of "deferred maintenance".

Why Real (Not Just Nominal) Costs Will Rise - And Why Price Inflation Didn't Happen Despite Huge Credit Increases in the 1990s

Suppose a rich kid, living in a small country that has long winters and heavy fuel use, inherits a huge factory. He (or she) decides to party more. To maximize income without working (much), our hero decides to stop replacing equipment for the factory.

The rich friends think he (or she) is a genius and they all decide to do the same thing. Word spreads by internet, TV, etc. and its a huge party.

Since replacement work takes energy and since energy demand is down, local fuel prices tend to fall. So do a lot of other prices. Former plant operators become day-traders. Foolish economists pronouce this as "deflation" because "GDP" is slowing. The central bank responds by increasing credit, which of course the national party group - as they call themselves - makes full use of. There's an asset boom on top of the party boom.

Party goods prices don't go up much because party goods aren't hard to produce (unlike oil or good medical research), so there's "huge productivity" and "no inflation" despite credit increases.

Sound familiar?

At some point, things get tough. Our hero and friends will have to start working with a lot less factory, a lot less assets, with even bigger debt - and the banks are really going to be upset about their collateral when they find the productivity of their debtors far too small to handle the debt load. The real assets have been consumed while financial assets have soared ... despite no apparent overall price inflation.

Of course a double brilliant economist decides that there's an even bigger market to inflate and that will bail the small economy out. The idea is to put "short rates at 1% and leave them there" to help the owners of financial assets maintain their values. But then consumption goods prices begin to rise as the economic structure produces less and less for every dollar of credit. Supply damage is now showing in all sorts of goods.

Quick on his feet, our brilliant economist writes a book and goes on tour just as the housing bubble bursts ... The rest of the population bears increased risk of loss because real estate debt is carried by banks which accept the deposits of the public. To prevent collapse, the government ends up financing the losses at the cost of the taxpayers and society is much poorer (with notable exceptions).

Does that result in inflation or deflation? Well some things sure are going to deflate, such as party attitudes and party goods.

If the authorities step in and "save" the banking system from bad credit, you can bet that if the central bank merely maintains the old credit level and doesn't expand credit, many prices are still going to rise from long neglect.

The central bank has to shrink credit to stop prices from rising -- genuine credit and monetary deflation.

Quite a few writers don't realize that simply "holding the line" is a price inflationary policy because of past mistakes, while underlying policy may in fact be non-inflationary. It takes substantial time for a stable policy to have price effects if supply has been damaged.

Welcome to now ...

But still,

Inflation and Deflation Doesn't Matter

Why?

Well, obviously inflation and deflation does matter because understanding the process gives you an investment edge and helps an investor manage his or her income exposure to economic changes. But an investor can't know which way things will go (or the exact timing) when the limits of credit expansion are reached. So whether we have inflation or deflation is the wrong question right now because:

1. An investor can hedge part of it away by splitting bets. Since that's the best an investor can reliably do, it doesn't make sense to spend too much time on the "final outcome".
2. Income is going to matter more than investments as asset deflation continues, despite price inflation or price deflation! Taking into account the decline in the dollar, U.S. assets have declined massively from their 2001 high, and the "bounce" in 2003 really wasn't one.

In my view, investors should consider ...

Possible Investment Policy For The Next 10 Years

1. Focus on earning a good income in an excellent wealth-creating field.
2. Split savings between inflation and deflation hedges.
3. Spend significant money and time developing productive assets and less on low-value consumption goods.
4. Invest in companies that make money producing valuable goods and services and stay away from modern "financial asset management" ideology. "Make money when you buy, not when you sell." (i.e. work on getting cashflow paying deals that have pricing power).
5. People need fun, too - but it may be (after denial is over), less extravagent fun for the average U.S. consumer, but still big money for the new wealthy. Obviously rules like #3 can be profitably broken.

Comments

[flow5]

In the latest move, total commercial bank credit (loans-deposits) is growing at an annual rate of 11%. MZM is growing at an annual rate of 16%. "Free gratis" legal reserves have increased - 5 percent.

The "monetary base" now consists primarily of "prudential" or "liquidity" reserves. I.e., reserves are no longer "binding/constrai... And the "money multiplier" has broken down and is now useless. Interesting analogies.

In the short-run that is a very loose monetary policy.

[flow5]

Some people prefer the devil theory of inflation: “It’s all OPEC’s fault.” This approach ignores the fact that the evidence of inflation is represented by actual prices in the marketplace. The “administered” prices of OPEC would not be the “actual” market prices were they not “validated” by (MVt)

(WTI Crude Futures (USD/bbl.) 114.950 April 16, 2008

[Malkiel]

Brilliant work, son, a veritable "theory of relativity" for money. I'd love to hear professor Bernanke (the Depression specialist) candidly mention at a congressional hearing some day the part about the Great Depression being a good thing because it got us off the gold standard...

[iThinkBig]

"The great depression got the population off of gold and allowed far greater federal debt and banking credit compared to money."

I stopped reading this article after this comment. Credit Adolph Hitler for bringing us out of the Great Depression. Don't think we want to try that again in a world of nukes and ME loonies. How about we simply stop manipulating the free market, repeal the Fairness in Lending Act which was nothing but Socialism at it's worst and create a viable alternative energy product to create millions of jobs and compete with big oil? Wow, I must be a genius! Sarcasm off and disgusted hat back on.

[JIMB]

flow5 -- MZM is growing because no one wants to "go long risk" ... if an investor sells mortgages and buys money market fund assets, that's not "soaring inflation" but a restructuring of debt ownership. The context makes all the difference.

Reserves haven't been binding for a decade, true ... and all that time credit has expanded, which means leverage is higher, not lower. That means if there's any financial accident, leaving reserves roughly the same is a policy of deflation.

A collapsing dollar is from past inflation .... We'll see if the Fed inflates by expanding money, or if the market decides to revalue existing credit (which would be inflationary).

Finally, rising prices isn't inflation. If I buy Xs and Ys, and Ys go up by $100 and I buy $100 less Xs, that's not inflation. It's when Ys go up by more than Xs go down (price x volume) that we can be assured inflation is occuring. When house prices went up ... and nothing went down, that was inflation.

[fxtrader07]

one of the really better articles to be found on SA and quite some food for thought. thanks to the author for sharing his views

[water_man]

Great Article. I'm an engineer, not a financial guy. I have trouble with the articles that are written for financial experts by financial experts.
Too much jargon. Please do more of these articles for the rest of us.

[water_man]

Please look at my website safersmallcars.com

It is my contribution to help save the world from climate change.

[L-bow]

Good analogies but on your recommendations: If I hedge against both inflation and deflation, isn't that the same as doing nothing? IE: By gold as an inflation hedge and short gold as a deflation hedge? LB

[JIMB]

L. Bow - Split the bet by buying a consistent dollar amount of different assets over time (monthly, bi-monthly, or quarterly). When a particular asset goes up, you automatically buy less of it relative to the other assets in your portfolio. You should rebalance your asset allocation periodically (usually each year) to move gains in rising assets into cheaper assets.

Example: save $250 per month and buy a commodities fund. At $20 per share you're going to buy more than if the fund share price is at $40. Hopefully your savings will increase over time (more income), but it should remain consistently upward as much as possible. The strategy works best when emotion is taken out, and varying the amount of savings means the investor is exposed to the emotions of the market and will usually tend to do worse.

If an investor had done this since 1980, by 2000 they would have owned a substantial amount of gold and non-dollar assets by taking their stock gains and buying gold and commodities. Although the investor would have lost the compound stock gains from 1980 to 2000 in the short run because of portfolio rebalancing, the risk profile is far different as the gains are not subject to catastrophic losses and periodic buying means the average asset isn't bought "at the peak". The protection of gains becomes more and more important the closer to retirement a person gets. This is a long run savings plan which tends to do very well.

The only environment in which the plan fails (as all plans would) is under a severe deflation when the investor is forced to sell at the worst time to survive. In reality, an investor can time the market to some degree by changing the rebalancing frequency of the portfolio. As a particular market goes asymptotic which the investor owns, rebalance the portfolio more frequently to reduce the risk.

[RobertTrudeau]

Good article. Of course the Fed oscillates between fighting inflation and deflation. We don't live in a perfect world. You failed to account for the Fed accepting mortgages as collateral for loans in your money supply calculations. Will 100% of the mortgages perform? Wouldn't the Fed accepting non-performing loans maintain the money supply at previously high levels? You are talking balance sheet magic. We are experiencing high inflation that will be followed by deflation, and the Fed will oscillate accordingly.

[Lucia]

Another excellent article. Always have clear head after reading your thoughts. Thank you.