By Jeff Harding
I received an interesting comment to my Mr. Sunshine article from Hans Palmstierna at Saving Capitalism. I suggested that we will see more deflation before we see inflation. Hans said:
I would argue that the “nominal” bottom is soon here. With the money now flowing at full speed (M1 at around 20% YoY growth) from every crack in the Federal Reserve, it should soon be impossible for the economy to contract in nominal terms. This doesn’t count for unemployment, of course, which may still rise for quite a while yet.
The only thing that can stop the “nominal” bottom is of course Bernanke slamming the brakes, but that doesn’t seem very likely now does it. Or possibly consumers growing wise and starting to save so much that they outdo the government spending – this would probably produce a L-shaped recession.
Here’s my response.
There is no question that M1 and related monetary components are expanding. Just looking at the Fed balance sheet, it has expanded dramatically, which means it is injecting money into the banking system.
Courtesy News N' Economics: Rebecca Wilder
The chart shows what has happened since last September. The chart estimates what other commitments the Fed has made through 2010.
However there are good arguments that this money has not yet hit the economy full force which leaves room for deflation. Deflation is just a downward revaluation of assets in monetary terms. I think we’ll see further asset devaluation in Asset Backed Securities such as securities backed by commercial mortgages, credit card debt, auto loans, and student debt.
I am not saying that we won’t eventually have inflation. There’s too much money waiting to hit the economy for inflation to not happen. I use the Austrian definition of inflation which is an increase in the supply of cash and credit by a central bank and a subsequent lack of demand for money. Or, to say it another way, printing dollars causes people to shed dollars causing an increased demand for goods, which results in higher prices. Prices going up is an effect of inflation, not inflation itself. Of course increasing prices is how we can tell we have inflation. The hallmark of inflation is that all prices increase, not just certain prices as a result of supply and demand factors in the marketplace.
It certainly appears that the Fed in increasing the supply of money. Money base shot skyward as the chart below shows.
St. Louis Fed M0
But …
The following analysis doesn’t come from me; I got it from Mike “Mish” Shedlock at his Mish’s Global Economic Trend Analysis blog. I highly recommend his blog for consistently excellent analysis. His well taken point is that all this money hasn’t hit the banking system yet because businesses are not borrowing and banks have tightened lending standards.
Here are the charts he uses which I have updated:
1. Excess bank reserves continue to be high, although they are declining since Mish originally published his article. It means that banks are sitting on their cash.
St. Louis Fed Reserve Bank Credit
2. The M1 Multiplier chart shows the ratio of M1 (the amount of currency plus demand deposits) to the Adjusted Monetary Base (currency plus bank reserves). It tells us that the base money expansion has not shown up in M1 money supply. It would be going up during inflation.
St. Louis Fed M1 Multiplier
3. Also recent bank surveys by the Fed show that businesses are reluctant to borrow, so banks aren’t just hoarding their cash. Also, total bank lending by the top 21 TARP recipients was down 11.9% from October, 2008 through February, 2009 (it was down 23.2% for the median).
Another important point Mish makes is that the spread between the 10 year Treasury bond and TIPS (Treasury Inflation Protected Securities) doesn’t yet reflect inflationary expectations. The spread on 10 year TIPS was 130 basis points which does not indicate demand for TIPS which means inflationary expectations are low.
While Treasury bond yields are rising, most investors believe yields will stay relatively stable:
Still, many bond-fund managers expect yields to stay within a band of 2.75% to 3.25% for the rest of the year. “I doubt it is going to 5% tomorrow or anytime soon,” says RidgeWorth Intermediate Bond’s James Keegan.
For one thing, the managers say, the government won’t relent in its efforts to hold down the 10-year yield, which is closely correlated to mortgage rates. Any big rise in mortgage rates would exacerbate the nation’s real-estate crash.
So, I think I’m OK with my near term prediction of deflation. There is some movement however, as reflected in the charts. Also, the CPI was up 2.2% for Q1 2009. I wonder, though, about the Fed’s determination to keep rates down. With all the commercial mortgages coming due during the next few years, rising mortgage rates (tied to the 10 year Treasury) will be under pressure.
It will be interesting.
Any thoughts on this out there?
Your points are very well laid out, and in the end it is of course a matter of *which* prices we expect to go up or down. What completely baffled me was when I pulled statistics on CPI, excluding the energy component. CPI has been growing rather steadily with 2-3% YoY all throughout this crisis. The HUGE fluctuations that made the FED go all bonkers (or think it was OK to go all bonkers), and set off Krugman on his manic “Liquidity trap”-rants seem to be very much due to the speculative oil-bubble that burst, and not so much related to other consumer goods. This is one of my main arguments why there won’t be any lower prices in consumer goods.
And if we look at it that way, consider the fact that the multiplier is extremely low, and prices haven’t gone down, it seems to me that any “deflationary effects” must be flukes, and the long-term trend is definitely inflationary.
What I am considering now is if it is even physically possible for the FED to stop the inflationary wave once it hits. If all they have on their balance sheet will be Treasuries that are falling in price, and “toxic assets” that no one wants to touch, how are they going to get money OUT of the system when that time comes? And even if they get to start issuing their own debt – this is only postponing the problem. In order to stop an increase in the supply of money by x%, they would have to pay interest on this debt above x%, which when it is due will mean they have to issue debt at x++%, and so on. The only way that the FED can avoid inflation is by ballooning their balance sheet further with growing liabilities to lock down some cash. In the end, I see no way out.
I’m not an economist so perhaps my thoughts on this can be of some value (for all you nascent economists out there: just kidding…not).
An observation one could make is that this government spending spree is analogous to World War II, when the nation’s “budget” (we should all refuse to use this term, since if any of us actually “budgeted” to spend nearly 50% more than we make per year, it could hardly be called that) deficit was considerably higher, yet not only did hyper-inflation not occur, but a period of rather robust growth followed. The impetus then was returning GIs and the GI bill and the subsequent building boom that increased demand for just the things the factories that had previously been building bombers and tanks were shifting into. It was a beautiful confluence of events and circumstances.
Things are different this time around, however. The nation’s ongoing and committed payments to retirees, welfare recipients, government employees, etcetera, are much higher today. It seems to me the likely scenario is that unionized and government employees at all levels will continue to receive higher wages and benefits than the private sector (minus CEOs, bankers, and other overly-high-paid folk) and that taxes will eat into private wealth. What happens then is what needs to be analyzed and, I know this sounds ridiculous, but the image of the Soviet Union comes to mind, whereby government and other favored types shop in special stores and live off the fat of the labor force while the rest of us line up for bread – at “controlled” low prices of course.
The other scenario is government actually holding spending in line by, say, freezing cost of living allowances and inflation-adjusted salary increases. If you believe that could happen with this crowd running things though, well, maybe if we put little Porky up high enough and push from behind with enough force, he really could fly, at least until he lands in the sty below.
Hans:
Are we looking at the same data? The CPI chart I have (St. Louis Fed), less oil, shows a steady decline in CPI. Oil peaked in July, 2008 and then took the plunge. The CPI has increased to 2.2% in Q1 09. So I’m not sure I agree with you. As you know “inflation” occurs when all prices rise. I’m not sure the oil thing had anything to do with inflation, but rather with speculation related to supply and demand. As I showed on my charts, you can see the recent blip in money reserves going down which indicates some changes in money supply which is hitting the market which could account for the Q1 CPI blip.
I have seen consumer prices go down with many retailers liquidating inventory. Also, housing prices have collapsed. I think the up numbers from retailers that came out today are a blip. Most sales are generated from discounting and inventory cutting (see the WSJ article). Also WMT sales went up because that’s where you save money–i.e., they benefited while more expensive retailers suffered.
I think the Fed-Treasury has many tools to stop inflation, after all, they caused it. They can raise reserve requirements, sell T-bills, and increase interest rates. I understand the dilemma that they have with a lot of toxic assets on their books, but they hold lots of T-bills and can sop of liquidity by reviving the Supplementary Financing Program they used last year.
Thanks for the comments.
Journal Jim:
Your questions make my head hurt.
Let me see if I understand your point. We spent like crazy in WWII and didn’t have inflation. Robust growth followed because we shifted from a wartime economy back to a civilian economy. Now, government spending will support increased entitlement programs, government workers, and union workers. These beneficiaries will receive higher wages/benefits than the private sector, supported by higher taxes. You analogize to the Soviet Union where Party members received special benefits not permitted to the masses.
Here’s how I see it:
1. Yes, GDP soared during WWII, the government borrowed heavily, taxed heavily, and we didn’t have hyperinflation.
2. There were price and wage controls that limited the effects of inflation.
3. After the War, the economy went into the tank. Heavy regulation left over from the New Deal and high taxation stifled growth.
4. In the late 1940s they reduced the heavy hand of the government and the economy took off, collapsed again in 1954, etc., etc. The Dow Jones didn’t recover its 1929 high until 1955!
5. But we did have growth. GDP expanded and debt was relatively a small percentage of GDP.
6. Inflation is an increase in the supply of money relative to the demand for money.
7. Government workers generally already are paid more than private sector workers.
8. Inflation is a given in the future.
9. Wage and price controls will be instituted to control it.
10. Interest rates will climb, shortages will exist, the economy will stagnate, the government will be voted out, we’ll go through really high interest rates, money supply will shrink, we’ll have a serious recession/depression, and it will start all over again.
Deflation near-term, inflation long-term. How long it might take for inflation to kick in remains to be seen. I would guess by the end of the year.
A deflationary trend tends to be self-reinforcing. So long as you think the house, the stock, the car, etc.. you want to buy will be cheaper the longer you wait, the longer you will wait to buy it. When enough people think like this, deflation results. When the consensus is reached that we have hit “the bottom” — and enough people start buying enough stuff again — deflation will stop.
Bernanke and co. have been trying to spur inflation, thinking: A) Making prices rise will encourage people to spend money again, hence get “the economy” going, and; B) It will make paying off the gov’t debt relatively cheaper in the long-long-term.
The gov’t has created too much money out of thin air — especially since August of 2008 — for significant inflation not to result. Seems to me the only question is: Will we have 1970′s-style double digit inflation/”stagflation”, or will we have hyperinflation?