Tag Archives: deflation

Deflation or Inflation? Yes

Since the beginning of the “Great Recession” that Americans still find themselves in, there have been prognostications of incredible inflation while other “experts” claim that crippling deflation would be the necessary outcome.  Could they both be right?

Perhaps – there are two major forces at play in our economy right now: price inflation and income deflation.

Price inflation

Wheat Prices

Commodities are going through the roof.  Oil is above $90 a barrel, corn is $6.07 per bushel, March wheat got as high as $8.05 a bushel this week soybeans, cotton, sugar .. you name it.

It’s not just food and clothing.  Copper, gold, silver are also much higher recently.  All of these commodities are building blocks for the food we eat, the clothes we wear and consumer items Americans need.

Oil prices hit twice as hard.  Not only is petroleum a raw material for plastics, medicines, food and clothing, but it is also used to fuel the trucks, trains, planes and ships that transport those goods to stores.

Now that the government is pushing to raise the amount of ethanol in gasoline, rising corn prices will also hit Americans in two places.  As a component of E10/E15/E85, it will increase the price at the pump.  As more corn is turned into fuel, the supply-demand curve will steepen and everything that has corn as an input will see raw material prices increase even faster.

Wage/Income Deflation

The American job market has not recovered from the recession and is likely to take several years to do so.  As The Wall Street Journal reports, this recession is already longer than the last wage period where wage deflation took hold.

The only other downturn since the Depression to see similarly large wage cuts was the 1981-82 recession. But the latest downturn is already eclipsing that one. Unemployment has stood above 9% for 20 straight months—longer than the early 1980s stretch—and is likely to remain above that level for most of 2011, putting downward pressure on wages.

With millions more workers seeking jobs than there are available, employers have gained a stronger position in pay negotiations.  The job market is incredibly competitive allowing employers to cherry pick the best talent for the salary dollar.

Another downward wage pressure is that employers do not have to give big salary increases or bonuses to keep talented employees.  A tough job market means fewer employees will be willing to leave and if they do, there is an ample pool of workers ready to take their place – perhaps at a reduced rate.

The Journal post shows evidence that these dynamics are cutting wages for American workers.

Economists had wondered how far this dynamic would go in this recession, and now the numbers are starting to show it: Between 2007 and 2009, more than half the full-time workers who lost jobs that they had held for at least three years and then found new full-time work by early last year reported wage declines, according to the Labor Department. Thirty-six percent reported the new job paid at least 20% less than the one they lost.

Prices Higher and Incomes lower – Inflation or Deflation?

Both.  Production costs are going up, but consumer buying power is falling off.

Consumers have to pay home heating costs, put gas in their cars, buy clothes and food.  If all of those things cost more, and consumers are making less money .. there is less consumer potential in the market place.  Welcome back the nemesis from the late 1970’s and early 1980’s: stagflation.

Remember the “misery index” from the 1976 and 1980 Presidential election?  The misery index is computed by adding inflation to unemployment.  If both are high, a stagnant economy and high inflation are present.  Stuff gets more expensive to make, but no one can afford it so the economy stagnates.

Jimmy Carter holds the current record of 21.98, but Obama’s current term is on a run taking the misery index from 7.73 at the beginning of his Presidency to 10.94 in November.  The current numbers are deceptively low for two reasons: the federal reserve inflation rate and bureau of labor’s unemployment numbers aren’t telling the whole story.

Anyone that has been to the grocery store or filled their car up with gas knows that things are much more expensive lately.  Because the government’s inflation measure does not include food and energy, it doesn’t take into account the very things that Americans simply must buy.  The incredibly low inflation rate reported by the fed is a sham and does not truthfully report the increase in living costs that Americans face.

The unemployment numbers are also portraying a false positive.  BLS statistics do not include those that have simply given up looking for work or have run out of benefits.  Unemployment is a measure of first time applications.  After 20+ months, not many first timers left to apply.  As this article from the Associated Press states, 9.4 is not as good a number as the President would have America believe (emphasis mine).

The unemployment rate did come down, to 9.4 percent from 9.8, but that was partly because people gave up looking for work.


All told, employers added 1.1 million jobs in 2010, or about 94,000 a month. The nation still has 7.2 million fewer jobs today than it did in December 2007, when the recession began.

Producers have been eating the increasing costs of their raw materials and transportation.  That practice is ending as margins have been squeezed as tightly as possible.  The cost to the consumer is going up, but the consumer now has less money to spend.  Stagflation, again..  oddly enough, under another progressive Democrat President that has been listening to Paul Volcker for economic advice.  Same players, same results.

Learning Economics From Chinese Students

As shameful as it is, a Chinese student gets what we’re struggling to understand – government policies are stifling consumption, exports and therefor the economy.

Bloomberg.com post mentioned that when a professor was discussing the nation’s move to keep interest rates low, a student chimed in with true wisdom:

Peking University professor Michael Pettis was discussing declining bank-deposit returns when a student interrupted with a story about her aunt that may stymie China’s plan to boost consumer spending.

“To send her son to university in six years it means she must replace each yuan in lost income with one from her wages,” the student said, according to Pettis.

Read it again, this example demonstrates one of the pressures that government-control of the economy (or in our case, Fed control) exerts.  By keeping interest rates artificially low, investment income is hard to come by through anything but the most-volatile markets: Bond yields stink, CDs are worthless, and savings accounts generate no appreciable income.  That means that savers now have less income to pay for normal expenses and that limits their ability to buy goods and services within the economy.  Without investment income, your paycheck is all there is and that’s not enough.

China’s problem is very much similar to ours:

“Consumption is already at a dangerously low level,” said Pettis, author of the “The Volatility Machine,” a 2001 book that examines financial crises in emerging markets. “If it doesn’t begin to rise very quickly, China has a problem because household consumption will continue to drop as a share of GDP.”

Consumption represents as much as 70% of U.S. GDP.  This lack of non-wage income, a large portion of income of retirees and near-retirees, means there is simply less to spend.  This represents another downward push on the supply of money.  If deposits in banks decline due to CDs and savings accounts being poor investments or not growing effectively, the banks have fewer assets to loan against.  We are a fractional reserve system and only money loaned creates more money.  As I discuss in this post on serious deflationary concerns, that’s the last thing we need.

As the post continues, it raises an interesting point that is of concern with Obama’s current direction.  It’s been well-publicized that the President would like us to rely more on exports and less on consumer spending to power the U.S. economy.

The Group of 20 nations has urged China to boost domestic consumer spending to help offset reduced consumption from debt- strapped consumers in the U.S. and Europe. If Chinese shoppers fail to take over that mantle as the government’s 4 trillion yuan in stimulus wanes, then the nation may have to fall back on exports for growth. That would revive trade disputes with the U.S., which is battling 9.5 percent unemployment, said Huang.

Great, protectionist trade battles to return:  Chicken tariffs anyone?

Low interest rates are intended to create investment through credit and therefor grow the economy, but left too long and in a disinflationary economy, they create a just the environment required to foster deflation.  As this article at AARP.com states:

On Thursday, James Bullard, the president of the Federal Reserve Bank of St. Louis, warned that the Fed’s current policies were putting the American economy at risk of becoming “enmeshed in a Japanese-style deflationary outcome within the next several years.”

So we’re keeping loose monetary policy because even the Fed has figured out that deflation is a real concern.  What’s startling is that the Fed’s next action will pull even more investment income out of the market.

Mr. Bullard, in an conference call with reporters on Thursday, said he was not calling right away for the Fed to drop its position that interest rates would remain exceptionally low for “an extended period,” or to resume buying long-term Treasury securities to stimulate the economy.

When the Fed buys Treasury bonds, it means they are infusing cash into the economy by buying U.S. Treasury debt: monitizing the debt.  This action will lower the rate on bonds (yields) which should make it less-expensive to borrow money.  In economics, there are two sides to every position.  If borrowing costs are low, lending incentive is minimized.  The risk-reward ratio gets out-of-kilter.  Why risk money for  measly 3% return?  If investor/saver mind-set is to stuff cash into a mattress, lowering interest rates won’t fix that and in-fact may make it worse.

A Chinese student uses a simple story to relate that the world may be heading into an unavoidable deflationary spiral.  Throwing money at it (stimulus), artificially lowering borrowing costs (fed actions) and just pretending that the recovery is happening (Obama and Biden on T.V.) are not the solutions.  It is quite possible that deflation is the solution to the bubbles that governments have caused over the last decade.  If we don’t let them occur, they will anyway.. just worse.  If that’s the case, are you prepared?

Federal Reserve Struggling to Create Inflation

The specter of deflation is looming.  Federal Reserve chief Ben Bernanke, the President’s economic advisor Paul Volcker (remember him from the Carter years?), and Treasury’s Timmy Giehtner are all worried that the inflation they have been trying so hard to elicit isn’t coming fast enough – or at all.

While inflation is what happens when too many dollars are chasing too few goods, deflation is the opposite.

According to about.com, inflation is caused by:

  1. The supply of money goes up.
  2. The supply of other goods goes down.
  3. Demand for money goes down.
  4. Demand for other goods goes up.

So one could draw a conclusion about the inverse – that deflation is caused by (parenthesis mine):

  1. The supply of money goes down (hmm, let’s talk about this one).
  2. The supply of other goods goes up (inventory growth – CHECK!).
  3. Demand for money goes up (people want more money than is available – credit crunch – CHECK!).
  4. Demand for other goods goes down (commodity implosion, consumers not spending, etc – CHECK!).

Let’s break down the criteria:

Money Supply Declines While Demand for Money Increases

With all the money the government has been printing, shouldn’t it all have come out in the wash? Sure, except Obama’s financial reform has put lenders and creditors in the mood to just hang on to their money.  This post in the Telegraph illustrates just how quickly the money supply is being depleted:

The stock of money fell from $14.2 trillion to $13.9 trillion in the three months to April, amounting to an annual rate of contraction of 9.6pc. The assets of insitutional money market funds fell at a 37pc rate, the sharpest drop ever.

“It’s frightening,” said Professor Tim Congdon from International Monetary Research. “The plunge in M3 has no precedent since the Great Depression. The dominant reason for this is that regulators across the world are pressing banks to raise capital asset ratios and to shrink their risk assets. This is why the US is not recovering properly,” he said.

The U.S. government has stopped tracking M3, they say because it’s too volatile (which the next graph will disprove).  I believe they just don’t want to have to address the fear that having to report on it would create.  Since they don’t track it, they don’t have to talk about or react to it.  At Now and Futures, they decided to track it themselves and the chart they produced shows that the pace at which the money supply is dropping is alarming at best:

M3 Money Supply

M3 Money Supply

There is also the issue of the availability of credit.  The sweeping regulations that the Obama administration has pushed for and gotten have paralyzed the credit markets.  Banks will only lend to the most credit-worthy and are being forced to hold historically high asset-to-credit ratios.  Small businesses and consumers can’t borrow even if they want to – in the case of small and medium businesses, they need to.  It just plain is getting harder to get the money we need.

Demand for money: up, supply down.

Supply of other Goods Rising vs. Demand for Goods Stays Low

There are both supply side and buy-side issues that are causing the over-supply issue.  Manufacturers built up inventories anticipating the “Recovery Summer” that the White House promised them and consumers aren’t buying.  According to Economic Populist, the consumer confidence index is taking a nosedive:

The Index now stands at 52.9 (1985=100), down from 62.7 in May. The Present Situation Index decreased to 25.5 from 29.8. The Expectations Index declined to 71.2 from 84.6 last month.

The latest GDP number showed a disconcerting decline in consumption.  The 2.4% overall number isn’t something that indicates much more than the economy treading water and certainly demonstrates weakening demand for our goods.  As the New York Times put it

Recent data suggests that consumers are using any extra cash they have to pay down debt or put into savings. That places a strain on an American economy that has become hugely dependent on consumer spending.

On Tuesday, the Commerce Department reported that Americans saved 6.4 percent of their after-tax income in June, in contrast to the years before the recession, when savings rates stood at 1 to 2 percent.

Last month, the Federal Reserve reported that consumer debt dropped by 4.5 percent in May, a $9 billion decline. It was the 20th consecutive month that figure has dropped. In 2007, consumer debt jumped by 5.7 percent or nearly $40 billion.

The weakening demand works its way down the supply chain down to even the most basic of commodities.  Gasoline stockpiles are rising because refiners ramped up production without an increase in demand.

Supply of goods: Up, demand: down.

So manufacturers have produced goods thinking the recovery has come (it didn’t), consumers have either decided to hang on to their cash or been unable to obtain credit from banks that want to hang on to theirs.  With our fractional reserve economy, lending creates money – if no one borrows, less money is created.  We now have too many goods with too few dollars chasing them: Deflation.

Why would the government want to create and grow inflation?  As Rand Paul puts it, “The government wants inflation because they can never pay this debt, so they look for a devalued currency because you pay back ten cents on the dollar it’s not as big a difficulty in paying off the debt.”  In Obama-speak, this gives the socialist-progressives more space within which they can enact huge government programs.  If the deficit gets too ridiculous, they get voted out and the progressive drunk-fest comes to an end.

Obviously, deflation does the opposite – our debt becomes impossible to pay back and the progressive elitists won’t have the money or political capital to complete the final crisis that would “fundamentally transform” America.

We know why the government is doing what they do.  Now.. what do we do?

Run, hide.  Ok.. none of those unless you’re being chased by a large carnivore.  During inflation, holding debt isn’t bad.  You have an asset that is holding its value while your money becomes worth less (hopefully not worthless).  So you’re house is worth $100,000, during the inflationary period, money becomes less worthy.  Your house does not.  If things level out with 10% inflation, you are the owner of a $110,000 dollar house the next year. You could sell the house and even though each dollar is worth 10% less, your house maintained it’s relative value so you get 10% more for it. The decline of the currency did not affect your house at all, just any cash you hold or things you purchase as new with it.

During deflation the opposite is true, debt is terrible (and even worse on depreciating assets: cars, electronics, etc).  You have a $100,000 house, you pay on it over time.  Once things level out.. you have a house worth $50,000 house but still have a $100,000 mortgage.  They have a cool term for that now: under water.  50% of your wealth has just drowned in your under water mortgage, and that’s the best situation.  Now you have to pay $100,000 (plus interest) for a $50,000 asset.  The real kicker is it will become much harder to get the dollars you will need to pay your mortgage in a deflationary environment (remember, money supply = down).   When deflation is on the horizon, get rid of debt.

Some will tell you gold is a hedge against deflation.. the same people that said it was a hedge against inflation: those who want you to help keep its price high while they sell it.  Gold is a terrible play during deflation.  You are buying a $100 coin at $100 today, in 6 months, it will be worth $50, but there won’t be very many dollars out there looking to buy your gold.  Now you’re stuck with something you can’t sell, can’t eat, and can’t use.. how does that work for you?  This holds true for any commodity.  Deflation means the buying power of cash is strengthened and the price of commodities and other goods drops.

As this Bloomberg.com post points out, deflation will put upward price pressure on bonds.  To keep borrowing costs low, they have to keep yields down and the Treasury has few tools left.  This will drive bond prices up and there interest rates lower.

“The U.S. is closer to a Japanese-style outcome today than at any time in recent history,” Bullard said, warning in a research paper released yesterday about the possibility of deflation. “A better policy response to a negative shock is to expand the quantitative easing program through the purchase of Treasury securities.”

If you agree that a bout of deflation is in the cards, and you want to invest some of it, put your money in .. well.. money: U.S. Treasuries.  The yields are terrible, but the price pressure will be dramatic and the U.S. government will create money if it has to in order to pay you.  If it hits, commodities (gold, oil, gasoline, wheat, etc) will take a serious hit – stay away from those.  Other than that, emerging market stock funds may be a play in anything other than a serious global deflationary trend.

If you are betting on the outright collapse of the currency, gold gets no better.  You can’t eat it, the supply of it is controlled under suspicious conditions  and it’s worthless in a barter system.  Look at the Confederate states during and after the civil war.. barter.. not gold was the method of exchange.

Being cash-rich and debt-free is the way to ride out a deflationary period.  You’ll have what everyone else needs – dollars.  Law of supply and demand puts you in the driver’s seat.

Economy Nearing Carter-Era Catastrophe – Volcker Present Again

Jobless RecoveryInterpreting the latest unemployment report could make one’s head spin, but there is valuable information in it other than the tragic 10.2% unemployment rate and the fact that the economy has shed an additional 190,000 jobs in the last month.  Yahoo news points at a separate survey that shows 558,000 more people were unemployed in October than September.  This discrepancy is due to the fact that once someone gives up looking for a job or runs out of benefits, they are not longer technically “unemployed”.

Paul Volcker, the President’s chief economic adviser, and others are pointing to the idea that perhaps this is a jobless recovery.  To be a jobless recovery – first, one would expect a recovery.  If the economy were recovering, credit wouldn’t be shrinking, banks would be mending, and consumers would be spending.  In direct contradiction to a jobless recovery:

5 banks failed this week, 121 for this year alone:

United Commercial Bank, San Francisco, CA
Gateway Bank of St. Louis, St. Louis, MO
Prosperan Bank, Oakdale, MN
Home Federal Savings Bank, Detroit, MI
United Security Bank, Sparta, GA

Consumer spending dropped by the largest amount in nine months:
Consumer Spending Falls In September, Biggest Drop In Nine Months

Consumer confidence drops in October:
Consumer Confidence Survey

Real incomes flat and spending drops relative to inflation:

Income Flat, Spending Falls as Consumers Stay Wary

The sources vary, but are consistent.  We are not experiencing a jobless recovery, we are heading into a jobless stagnation.  This is exactly where we were during the Carter years, we are following the same actions under some of the same people, and are expecting a different result.

Many credit Volcker’s fed for ending inflation during the Reagan era by invoking a recession to reign-in out-of-control inflation.  The problem being, we don’t have any inflation.  With real-incomes dropping, consumption dissipating and credit drying-up, there is not way for producers to raise prices and expect anyone to buy much of anything.  So is the recent push of massive government spending an attempt to re-ignite inflation so that Bernanke and Volcker can work together to end it and save us all?

Carter era gas lines

Carter era gas lines

During the early 80’s, Volcker created a recession on purpose by tightening monetary policy.  His Keynesian theory then was that it was more important to reign-in inflation than save jobs.  This measure was actually needed only because of  failed Keynesian thought that continuing inflation was good for the economy.  Using monetarist policies, he corrected what Keynesian thought had brought about.

The problem now is that we don’t have job growth and we don’t have inflation.  The massive amounts of cash being poured into the economy by the Fed are not inducing price increases, it’s just watering down the money supply.  Money is being dumped into the stock market at alarming rates, mainly because there’s nowhere else for it to go.  Buying bonds is self-defeating considering the Treasury rates, investing in business at this time is suicidal.. Bernanke is using failed tactics probably at the behest of Obama’s chief adviser on the economy.  Monetary deflation with no corresponding economic inflation.

This looks like an orchestrated attempt to cause inflation so that we can do the same things that we did before.  Dump trillions into the economy and eventually producers will raise prices… well..  what if they don’t?   What if we just end up with a dept to income ratios (debt-to-GDP) rate of 70%+ (we’re at 66% by the way)?  We could easily end up spending everything that comes into this country to just service debt.  The Japanese have lost a decade of growth to thinking like this.

It’s time to cut spending, quit dumping money into the economy, let the pain correct the bubble that exists and move forward.  The Fed created the near hyper-inflationary mess that cost Carter his Presidency, made a mess during Bush’s stay, and is trying to put us in a place where they have any clue of what to do.  I am fairly certain that they don’t know how to get us to that place or a healthy economy.

While Obama is busy blaming bush, he has kept on the one person probably the most-responsible for the mess we have – Bernanke.  The President has also brought Carter’s Volcker back into the mix and Barack is egging them both on.  One can hope this is more due to nativity than purpose.