The inflation – deflation debate redux

I’m getting a lot of mail about the Rosenberg post and my mea culpa on inflation. To be blunt, a lot of you think I’m out to lunch and Rosenberg is too — after all inflation is over 5% and that’s just the bogus CPI measure our governments release.

But, alas, there is method to my madness on inflation. Here’s my thinking:

My baseline argument is that the world’s central banks were way too easy with monetary policy after the recession of 2001 and 9/11. Basically, they saw a deflationary threat and panicked. The result has been inflation.

To be sure, there was plenty of inflation before 2001 — it was just channeled toward asset prices instead of consumer prices because the deflationary forces of China, India and the collapse of the Soviet Union brought a lot of workers into the global capitalist world. So, before the so-called deflationary threat, all of that excess money bid up only asset prices because global wage arbitrage kept it from hitting consumer prices (think DVDs, LCD screens, toys, clothes and so forth — all made in China).

However, once the global housing bubble collapsed, the asset class of choice became commodities and those same inflationary forces started to work their magic in the commodities sector. Unfortunately for central banks, commodities are an asset class that feed right into consumer price inflation. So the central banks have not had the same ability to reflate after the housing bubble because inflation is now popping up in consumer prices. As an inflation hawk, I was pretty vocal in calling out against the Fed’s easy money policy (I still think it’s wrong because it’s basically surreptitiously stealing money from citizens through devaluing the currency).

Funny thing is though — inflation has a way of killing consumer demand; it’s called demand destruction. So, the rise in food and oil prices has cratered demand for oil and really undercut consumption to the point where the global economy is in recession. Spain, Denmark, Germany, Italy, the U.S. and Canada have all recently posted negative or near zero GDP numbers. Japan looks to be in recession as well. There is no way inflation will continue to rise in this environment unless oil prices go back up due to some exogenous shock.

So, barring an Israeli-Iranian war or the like, we should expect oil to deflate to $100 a barrel and inflation to recede. Remember, core inflation (ex. food and energy) has yet to become too worrying. What does this mean for the global economy?

  1. Expect inflation to push up for a few months due to unfavorable year-to-year comparisons, but then to recede starting near the end of this year.
  2. The rise in oil has already done its damage: the global economy is in recession and this means jobs will be lost and companies will go bankrupt.
  3. Writedowns from the housing bust will continue unabated because of the faltering real economy. This means stress for the financial sector.

And ultimately this confluence of events means credit availability will be in short supply. No credit = no growth = no inflation. In fact, financial services companies will be deleveraging i.e. cutting lines of credit to companies and individuals in order to shrink their balance sheets.

For example, if you were Morgan Stanley and the U.S. economy was headed for a protracted downturn would you

a. increase credit lines to homeowners, hoping it would single-handedly pull the economy out of recession?

b. restrict credit to bad companies and those with poor credit as you need to be prudent? or

c. Panic and reduce credit all around, especially HELOCs (Home Equity Lines of Credit)?

As you probably know from reading the news, the answer has been and will continue to be

c. it’s panic time on Wall Street, Bay Street and in the City of London.

The only conclusion I can draw from this is that the lifeblood of our capitalist system, credit, will be contracting and this means deflation is a real threat going forward. While I have been concerned about inflation up until now, the evidence coming out in the last few weeks suggests the global economy is in recession and that deflation is really what we need to be thinking about from here on.

  1. John East says

    As a gold bug praying for $1000+ gold again I’m probably clutching at straws here, but doesn’t your analysis, which makes perfect sense to me, presuppose that Bernanke sits on his hands whilst your deflationary story unfolds?

    Hasn’t Bernanke promised over and over again that he will stop at nothing in any fight against deflation, even if it means giving freshly printed money away to US citizens?

    OK, he hasn’t been juicing the money supply any more than usual lately, and it’s hard to see how he can get the amount of money into the system that would be needed to reinflate, but he’s sure to do something over the next 6 months even if it’s only something short term to buy some Republican votes.

    I just can’t work out what that something might be.

  2. Sobers says

    Mark up one conversion to the deflation side! Events will tell whether you have joined the correct camp. However I think you have.

    All the indicators point to demand destruction/recession in all major global markets. When the current spike in inflation falls out of the indices some time later this year and in early 2009, what will cause any upward pressure on prices? Nothing that I can see. I predict inflation falling well below the target 2% in the UK and by late 2009 the problem facing central bankers will be how to re-inflate their economies, not suppress inflation. Asssets will continue to fall in price. Cash will be king. The only problem will be where to put it as banks will under severe pressure too. I foresee more runs on banks and at least one large bank failure in each major economy.

  3. Edward Harrison says

    Bernanke will do any and everything to prevent deflation from occurring including the unusual as he has shown already.

    But, the fed only controls short term interest rates and the base money supply. They don’t control the money multiplier, long-term rates or credit.

    So they can’t make people borrow or make banks lend. Ultimately, the Fed will have to come up with some way to inject itself into the credit markets if this de-leveraging continues to unfold.

    And, by the way, deflation is not bad for gold per se. Roosevelt devalued the dollar 40% AFTER the Bear move from 1929-1932. Gold still seems like a good hedge.

  4. dearieme says

    I’m with you as far as you go: current inflation then deflation. But if the central banks try to fight deflation by restarting an inflation, and judge it wrongly, we could get a second, and worse, wave of inflation. Which countries would constitute “we” is hard to know; USA and UK, very likely, and perhaps lots of others.

  5. Stevie b. says

    Dearieme is right – we must aim to reflate relatively slowly to allow the time necessary for commodity exploration and production to expand to meet increased global demand. If faster growth becomes the only yardstick of success, the next cycle will veer towards hyperinflation. One way out is for growth to be predicated on global warming – even if this apparent truth proves to be an illusion. The next superindustry should be energy-related alternative technology.
    And perhaps we have misjudged world trade. We assume global production will shift to the countries most efficient in each area, but this leaves us vulnerable as many such countries do not of course have the same democratic and stable basis to their societies. You only need to look at the potential ramifications from Georgia/Russia to see how vulnerable the world is becoming to this sort of situation. Perhaps a change of emphasis, where possible, to greater “domestic” production of more of the vulnerable necessities of life will also help us out of the deflationary mire.

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