The Fed is Deflating: 10 Reasons Why

Includes: DIA, QQQ, SPY
by: Jim Bradley

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.