This is Part 2 of a four part article that deals with what I feel is the primary question investors must now answer: is our future to be inflation or deflation? The answer has vast implications to our investment planning and decisions for the near term, and possibly for our long term. It is a very complex question with a lot of moving parts involving economics and politics.
Like it or not, it is economic theory that is driving macroeconomic policies and political decisions that determine whether we will have inflation or deflation. Since not all of my readers are sophisticated traders I have tried to present the issues in a direct and hopefully understandable way. To those sophisticated readers, please bear with me.
Part 2
The Inflation Argument
The argument for inflation rests on the money supply charts. The inflationists show various measures of money supply increasing, including the version used by Austrian theory economists, called True Money Supply (TMS)[1]:
Note: The M1 chart shown in Part 1 more clearly shows the trend in the M1 money supply increase.
Again, the YoY percentage change is more revealing:
The inflationists also point to the Consumer Price Index (CPI) which shows price increases:
The YoY rate of change of the CPI clearer:
As the chart reveals, prices have been rising since mid-2009. Even the measure of Core CPI (CPI less energy and food, CPILFENS) appears to be rising:
The inflationists would say that this effect of inflation, rising prices, is a classic measure that proves new money is hitting the economy and that has caused, among other things, prices to rise.
The Deflation Argument
The deflationists have a different take on the data. They point to theories by economist Steve Keen which states that first banks make loans, and then the Fed increases money supply to meet demand. According to Keen and Mish, money supply is created first by banks making loans, then by the Fed supplying the money, because you can’t increase money supply without getting it into the economy. If there is no lending the money supply remains unchanged. Thus it is a rise in credit that leads to money supply growth.
Mish also argues that excess reserves don’t really exist; they are a fiction created by the Fed, a mere computer entry. If you consider all the loans made by lenders, and the actual or potential defaults of their loans, those losses would absorb all the “excess” reserves. Therefore, those “reserves” are more or less spoken for and don’t represent money for making new loans.
Mish also believes that reserves aren’t the problem with banks; rather it is their shaky capital base. Lending is constrained by their lack of capital and financial instability rather than by reserves.
The deflationists say that because the size and breadth of the crash in the real estate markets and related debt, the problem is too big for the Fed to handle. Until debt is deleveraged and banks and businesses repair their balance sheets, the Fed’s effort to increase the money supply is like pushing on the proverbial string.
The result is that real estate asset prices are declining and that results in deflation. They say it is similar to what the Japanese experienced in the late ‘80s and ‘90s, when they experienced almost zero growth, no inflation, and declining asset values. Banks, they say, are not going to lend until this deleveraging occurs and businesses become solvent and creditworthy.
The deflationists say that the current measures of prices are inaccurate because they don’t reflect the declining values of real estate. If real estate was factored in, then prices would be shown as declining. The only measure of real estate in the CPI computation is what is called the real estate rental equivalent which measures the rental value of homes rather than their asset value.
They suggest that prices are indeed falling anyway if you look at Core CPI (CPI less energy and food) on a year-over-year percentage change basis:
Obviously there is some evidence of declining prices as shown by this chart.
Which is it: Inflation or Deflation?
Let me suggest a way of looking at the problem.
We understand that inflation or deflation is a monetary phenomenon, not just an increase or decrease in prices. And, in order to cause inflation new money must find its way into the economy.
There are several ways the Fed can do that.
The Fed can make cheap money available by lowering the interest rate on money it lends out, which increases money supply. Even with the Fed Funds rate at 0.18%, effectively zero, this doesn’t seem to be working.
The Fed can make it easier for banks to lend. This seems to be a problem for the Fed right now. As we have seen previously, lending is way down, excess reserves are high, and the money multiplier has fallen dramatically. This hasn’t worked either.
Yet money supply has been increasing despite the failure of these policies.
There is another tool in the Fed’s arsenal called Open Market Operations (OMO) whereby it buys and sells securities with its primary dealers. For example, buying Treasury paper from dealers increases money supply and selling decreases money supply.
Starting in January 2009, the Fed began a program of buying mortgage backed securities (MBS) issued by Fannie, Freddie, and Ginnie Mae. At its peak, they bought $1.25 trillion of these assets, pumping up money supply by that amount. The purpose was to get liquidity into the economy and try to revive credit and economic activity. Further it absorbed the risk of these “toxic” assets, relieving the former holders of their bad investment decisions.
This form of money inflation does not have the impact of the money multiplier were those funds in the hands of bankers who would lend out the new money, but it does represent a substantial amount of new money injected into the system.
This money infusion is being used by the very willing sellers of these toxic assets, the big investment banks or the investment banking operations of the big commercial banks, not so much for making loans, but for their own investment purposes; this money has been driving the financial markets.
Deflationists vs. Inflationists vs. Modified Inflationists
This is the point where the inflationists and deflationists part. The inflationists believe that the Fed can and will increase the money supply any time they wish through open market operations. The deflationists believe it doesn’t matter what the Fed will do because banks are not in a position to resume lending, thus counteracting the Fed’s attempts at increasing the money supply.
I have a different take on this, but it is a bit complicated to explain. To try to put it in a nutshell:
- I don’t agree with the deflationists that we will be just like Japan: continued deflation which would be the result of keeping alive bankrupt (zombie) banks and corporations.
- I part a bit with inflationists because I don’t believe Open Market Operations will have the inflationary impact they believe will occur. I believe that bank lending, the best tool for inflating money supply will remain constrained and be a drag on the economy.
- I believe that as the economy goes into a double-dip recession, the Fed will create ways to inflate that will be effective.
I refer to my position as Modified Inflationism.
Predictions and a Decision Tree
Here is the problem in trying to forecast what will happen in the future: tell me what the Fed and the government will do. Remember the Freakonomics’ humorous take on forecasting:
The future will be different from the present to some degree and some point, and I have anecdotes and hearsay to prove it.
Austrian types don’t believe that you can use econometric models to predict the future because such models are usually wrong. You can’t distill millions and millions of economic decisions down to a simple or even complex formula of human behavior because the data set is too vast to be useful. We believe you have to understand why individuals do things in the economy first before you can study data. These were some of the breakthroughs of the great economists Mises and Hayek.
To figure out what the Fed might do involves a lot of probabilities. And that is my method of analysis: what are the probabilities that the Fed will do one thing rather than another when faced with different circumstances. It is much like constructing a decision tree to see where they can go. If X happens, then the Fed’s choices are A, B, and C. What are the consequences of each and what is more likely to happen.
Stick with me.
Tomorrow, Part 3. The double dip economy, the Fed’s choices, and their fear of deflation.
After Part 4, I will publish the entire article as one downloadable PDF.
[1] The True Money Supply (TMS) was formulated by Murray Rothbard and represents the amount of money in the economy that is available for immediate use in exchange. It has been referred to in the past as the Austrian Money Supply, the Rothbard Money Supply and the True Money Supply. The benefits of TMS over conventional measures calculated by the Federal Reserve are that it counts only immediately available money for exchange and does not double count. MMMF shares are excluded from TMS precisely because they represent equity shares in a portfolio of highly liquid, short-term investments which must be sold in exchange for money before such shares can be redeemed. It includes: Currency Component of M1, Total Checkable Deposits, Savings Deposits, U.S. Government Demand Deposits and Note Balances, Demand Deposits Due to Foreign Commercial Banks, and Demand Deposits Due to Foreign Official Institutions. There are different takes on TMS. See http://mises.org/content/nofed/chart.aspx?series=TMS.
Hi Jeff,
Just a thought that struck me while reading (I too have been pondering this inflation/deflation dilemma constantly) : Assume the FED continues monetizing (which I think chances have it they will), and manage to keep both consumer prices and asset prices somewhat stable (no new lows for the stock market, no “crash” for housing rather a slow decline, no cpi hyperinflation etc.). Assume further that this goes on for between 2 and 10 years. This would basically seem to be their plan to avoid a “great depression” scenario or a “Japanese deflation” scenario.
What these IDIOTS do not seem to realize is that they are just removing the symptoms and not the disease. I predict the US economy, assuming nothing collapses, will be HORRIFIC under such a period with constantly sinking levels of wealth on all levels of society. Unemployment sticks, inflation is worrysome but not disastrous (while the phony CPI shows right-on-target 2-3%) and asset markets keep slowly slogging downwards.
Finally, the case for hyperinflation : If they actually succeed in putting the US economy into a slow zombielike slide downwards, they are flying completely in the blind when it comes to economic indicators. How are they to know when enough bad debt has been cleared and deflationary pressures subside? Japan has managed this slide for 20 years, but I think it’s more stupid luck than anything else that they haven’t accidentally hyperinflated their currency. Considering the US twin deficits (fiscal and trade), I would not give the US 20 years. More like 2, before the whole finance system cracks open and all the rot goes public.
As always, thanks for excellent analysis, looking forward to part 3 and 4.
// Hans
Thanks Hans, good comment. I don’t think consumer prices will remain stable. I discuss this in Parts 3 and 4. Let me know what you think.
Speaking as a deflationist, I think we agree in most respects. The only question is *when* the currency collapses, which Mises called a “crack up boom”.
I think the reason he used that term is that it is not a function of expanded or expanding bank lending, but rather a collapse in confidence in the paper money system. There is no demand as Austrian economists would think of it, no sustainable production. Just one final binge of frantically trading paper scraps for something, ANYthing that won’t go to zero tomorrow.
I think this sort of collapse is an exponential, rather than linear, process. One day you will be able to fill the car with gas by charging, say, $250 on your credit card. The next day, it will be $500 and paper cash only. The following week those few gas stations who have anything left will not accept paper…
Right now, we have two massive forces opposing one another. We have the asset price collapse following decades of asset price increases due to inflation. Of course when the price of a leveraged asset goes down, the debt remains. Most banks, businesses, and individuals are insolvent (equity < liabilities).
We also have massive monetary debasement. The government is spending money it doesn't have at the rate of trillions per year.
We can see the former in the price of non-essential or luxury goods: down about as much as houses. We can see the latter in the price of gold.
I hold the view that one doesn't cancel the other. Monetary debasement is bad, even if collapsing demand holds prices constant. Debt defaults are going to be horrendous, whether they are done the honest way or by printing ever more money.
Of course, our money supply is itself "backed by" debt. There is no way for the monetary system to survive systemic debt defaults, so that would lead to a currency collapse. Or, if they print enough to make good on it, that will also result in a currency collapse.
This result is baked in the cake, in my view, because one way or the other the paper accounting must catch up to what has happened in reality. And, in reality, the inflationary booms have tricked people into thinking they were much richer than they really were. So they consumed and malinvested their capital. Now the capital is destroyed. You can account for this by marking the asset side to zero and then defaulting so the liability side is also zero. Or you can stretch the unit of account so that the asset side is inflated to match the liabiltiy side, but only in currency units that are worth far less than they are today.
There are a lot of things that can happen before we reach crack up. I have a less hysterical view of what is happening. Not to say your view is hysterical; I understand the implications. Please read parts 3 and 4 and then let me know what you think. Thanks for reading my article.
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How can you possibly get an accurate figure on inflation or deflation without figuring energy or food prices?
Good point. But many economists use this because they feel Core is less volatile and is more accurate of true inflation. I would agree with you.
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First of all, thank you for presenting this in such a concise and easy to understand way. I took an interest in this about a year ago and I’m beginning to understand some of this stuff. But this article is the best one I’ve read attempting to deal with inflation\deflation argument.
One point that I think is extremely important in all of this and that I don’t think you directly addressed is the bailouts and the change in mark to market rules. Aren’t these the real game changers that are really screwing up everyone’s models? For any model to work, doesn’t there have to be SOME rules? How can any model predict that a governing body will one day just decide to “deem” the banks solvent via the removal of mark to market requirements? Without this one move, trillions would have disappeared from the economy almost overnight.
Isn’t this really about moral hazard and if that’s the case, how can anything be predicted – other than perhaps the total destruction of the world’s economies?
You are correct that the government can’t “deem” anything without the laws of economics catching up with them. I deal with MTM in parts 3 and 4 as being on of the main problems. Stay tuned. And thanks for reading!
ZIRP? No, by definition the interest rate “floor” is the remuneration rate. There is no “liquidity trap”.
Why? because the money supply can never be managed by any attempt to control the cost of credit (whether the FFR & IORs)…the liquidity preference curve is a false doctrine & the Taylor Rule is a ficticious “sign post” (see Alfred Marshall’s “money paradox”).
The FED is “pushing on a string” with its new policy tool – IORs.
What the FED has fostered is a contractionary policy with the use of a penalty rate.
The floor on the FFR (or the interest rate on excess & required reserves), now @ .25%, has created dis-intermediation among the non-banks (an outflow of funds), and has reduced money velocity, in the thrifts, as well as the CB system.
IORs have caused massive portfolio shifts in the earning assets among the commercial banks ($1,047,858T in new excess reserves).
These portfolio shifts have induced system-wide bank credit contraction (the remuneration rate on IORs will have exceeded all 4-week, 3-month & 6-month Treasury bills for 2 years as of this Nov 5th). Back then, the target FFR was @ 1% (on 11/05/08).
Nominal GDP will cascade in the 4th qtr (down in every month – Oct, Nov, & Dec), without extra (upwards of the linear path), stimulus
(1) Ben S. Bernanke
Chairman and a member of the Board of Governors of the Federal Reserve System. Chairman of the Federal Open Market Committee, the System’s principal monetary policymaking body.
At the same time, because economic forecasting is far from a precise science, we have no choice but to regard all our forecasts as provisional and subject to revision as the facts demand. Thus, policy must be flexible and ready to adjust to changes in economic projections.
2) European Central Bank (ECB) Central Bank for the EURO
The transmission mechanism is characterised by long, variable and uncertain time lags. Thus it is difficult to predict the precise effect of monetary policy actions on the economy and price level…
3) Janet L. Yellen, President and CEO of the Federal Reserve Bank of San
Francisco
You will note that I am casting my statements about the stance of policy and the outlook in very conditional terms. I do this because of the great uncertainty that surrounds these issues. Frankly, all approaches to assessing the stance of policy are inherently imprecise. Just as imprecise is our understanding of how long the lags will be between our policy actions and their impacts on the economy and inflation. This uncertainty argues, then, for policy to be responsive to the data as it emerges, especially as we get within range of the especially as we get within range of the desired policy setting.
(4) Thomas M. Hoenig
President of Federal Reserve Bank of Kansas City
Monetary policy must be forward-looking because policy influences inflation with long lags. Generally speaking a change in the Federal funds rate may take an estimated 12-18 months to affect inflation measures….But the course of monetary policy is not entirely certain. & will depend on how the economy evolves in the coming months.
(5) William Poole*
President, Federal Reserve Bank of St. Louis
However inflation is measured, economists agree that monetary policy has at most a minimal influence on the rate of change in the price level over relatively short time periods—months, quarters or perhaps even a year. Central banks are responsible for medium- and long-term inflation—such inflation, as Milton Friedman wrote, is a monetary phenomenon that depends on past, current and expected future monetary policy. As a practical matter, the medium- to long-term likely is a period of two to five years.
(6) Robert W. Fischer – President Dallas Federal Reserve Bank
November 2, 2006:
“In retrospect [because of faulty data] the real funds rate turned out to be lower than what was deemed appropriate at the time and was held lower longer than it should have been. In this case, poor data led to policy action that amplified speculative activity in housing and other markets. The point is that we need to continue to develop and work with better data.”
(7) Governor Donald L. Kohn
I think a third lesson is humility–we should always keep in mind how little we know about the economy. Monetary policy operates in an environment of pervasive uncertainty–about the nature of the shocks hitting the economy, about the economy’s structure, and about agents’ reactions. The 1970s provide a sobering lesson in the difficulty of estimating the level and rate of change of potential output; these are quantities we can never observe directly but can only infer from the behavior of other variables.
(8) James Grant (Grant’s Interest Rate Observer)
“Both use quantitative methods to build predictive models, but physics deals with matter; economics confronts human beings. And because matter doesn’t talk back or change its mind in the middle of a controlled experiment or buy high with the hope of selling even higher, economists can never match the predictive success of the scientists who wear lab coats.”
———————————————————————————————————————–
First, there is no ambiguity in forecasts: In contradistinction to Bernanke (and using his terminology), forecasts are mathematically “precise” :
(1) “Money” is the measure of liquidity; the yardstick by which the liquidity of all other assets is measured.
(2) Income velocity is a contrived figure (fabricated); it’s the transactions velocity (bank debits – Vt) that’s important (i.e., financial transactions are not random);
(3) Nominal GDP is the product of monetary flows (M*Vt) (or aggregate monetary demand), i.e., our means-of-payment money (M), times its transactions rate of turnover (Vt).
(4) The rates-of-change (roc’s) used by economists are specious (always at an annualized rate; which never coincides with an economic lag). The Fed’s technical staff, et al., has learned their catechisms;
(5) Friedman became famous using only half the equation (the means-of-payment money supply), leaving his believers with the labor of Sisyphus.
(6) Contrary to economic theory, & Nobel laureate, Dr. Milton Friedman, monetary lags are not “long and variable”. The lags for monetary flows (MVt), i.e. the proxies for (1) real-growth, and for (2) inflation indices, are historically, always, fixed in length. However, the FED’s target, nominal gdp?, varies widely.
(7) Roc’s in (MVt) are always measured with the same length of time as the specific economic lag (as its influence approaches its maximum impact (not date range); as demonstrated by the clustering on a scatter plot diagram).
(9) Consequently… by using simple algebra, economic prognostications are infallible (for less than one year).
This is the “Holy Grail” & it is inviolate & sacrosanct: See 1931 Committee on Bank Reserves Proposal (by the Board’s Division of Research and Statistics), published Feb, 5, 1938, declassified after 45 years on March 23, 1983.
(11) The BEA uses quarterly accounting periods for real GDP and the deflator. The accounting periods for GDP should correspond to the specific economic lag, not quarterly.
(12) Monetary policy objectives should not be in terms of any particular rate or range of growth of any monetary aggregate. Rather, policy should be formulated in terms of desired roc’s in monetary flows (MVt) relative to roc’s in real GDP.
(13) Combining real-output with inflation to obtain roc’s in nominal GDP, can then be used as a proxy figure for roc’s in all transactions. Roc’s in real GDP have to be used, of course, as a policy standard.
(14) Because of monopoly elements, and other structural defects, which raise costs, and prices, unnecessarily, and inhibit downward price flexibility in our markets, it is advisable to follow a monetary policy which will permit the roc in monetary flows to exceed the roc in real GDP by c. 2 – 3 percentage points.
(15) I.e., monetary policy is not a cure-all, there are structural elements in our economy that preclude a zero rate of inflation. In other words, some inflation is inevitable given our present market structure and the commitment of the federal government to hold unemployment rates at tolerable levels.
(16) Some people prefer the “devil theory” of inflation: “It’s all Peak Oil’s fault”, ”Peak Debt’s fault”, or the result of the “Stockpiling of Strategic Raw Materials/Industrial Metals” & Soaring Agriculture Produce. These approaches ignore the fact that the evidence of inflation is represented by “actual” prices in the marketplace.
(17) The “administered” prices of the world’s monopolies, and or, the world’s oligarchies: would not be the “asked” prices, were they not “validated” by (MVt), i.e., “validated” by the world’s Central Banks.
Theoretical framework from Dr. Leland Pritchard, PhD economics, Chicago 1933, MS statistics
You need to check out TMS1 vs TMS2
http://trueslant.com/michaelpollaro/files/2010/06/Austrian-Money-Supply.pdf
I referred to them in my blog
http://globaleconomicanalysis.blogspot.com/2010/03/true-money-supply-tms-vs-austrian-money.html
In am a fan of TMS1 (siding with Shostak) for reasons cited. Others disagree.
Regardless, the mises site is inaccurate and does not represent the positions of the people it claims.
Please shoot me an email
Mish
Hope you will explain why on the following in Parts III and IV:
1. I don’t agree with the deflationists that we will be just like Japan: continued deflation which would be the result of keeping alive bankrupt (zombie) banks and corporations.
3. I believe that as the economy goes into a double-dip recession, the Fed will create ways to inflate that will be effective.
Unlike point 2, neither 1 nor 3 has fact or logic backing so far.
Stay tuned. This is addressed in Parts 3 and 4.
Thanks for your articles. I am in the non-sophisticated category of which you speak. I think my problem is not in understanding what you are saying, which is quite clear, but in understanding the “flow chart” of money or credit. It’s ether-like to me when you speak of “Open Market Operations (OMO) whereby it buys and sells securities with its primary dealers” because the only words I really understand in that sentence are “buy” and “sell.” I’d love to see a primer on the Fed/Banks/Bonds/Securities/fannie etc. and how they relate so that I could understand the inflation/deflation argument better. Thanks again.
I’ll see if I can find some articles that would give you a good explanation. Thanks for reading!
I’ll keep reading but if you do come across a primer type article please pass it on. Thanks.