The Great Inflation Versus Deflation Debate

Those arguing for deflation won round 1 of the great inflation versus deflation debate. We've got deflation, and we've had it for some time (and see this).

Now, many people think we'll have sizable inflation in the near future. For example, one of the leading experts on interest rates warns that massive inflation looms unless the government starts raising interest rates now.

But David Rosenberg and Tyler Durden argue - as Mish has long argued - that consumers are so deeply in debt that we won't pull out of deflation for a while. They argue that while there has been an enormous flood of money injected into the economy by the government, the amount of wealth destroyed by the financial crisis is much greater.

Indeed, Rosenberg:

Expects Americans to retrench ferociously as 78m baby boomers face the looming threat of penury in old age. "The big story is that the personal savings rate hit a 15-year high of 5.7pc in April. I believe it could test the post-War peak of 15pc. Too many pundits are still living in the old paradigm of Americans shopping till they drop".

In other words, inflation won't occur until consumers start spending more and saving less (which would increase the velocity of money - the rate that a dollar turns over in the economy). But as a new survey of economists shows, high unemployment will drive consumer spending downward.

And Ambrose Evans-Pritchard argues:

The velocity of circulation has collapsed, and unemployment is rising everywhere? The Fed's "monetary multiplier" ended last week at 0.867, half its average of 1.7 over the last decade. The credit mechanism is still broken. This is what happened in Japan in its Lost Decade...

The list of countries in deflation is growing every month: Ireland (-3.5), Thailand (-3.3), China (-1.5), Switzerland (-1), Spain (-0.8), the US (-0.7), Singapore (-0.7), Taiwan (-0.5), Belgium (-0.4), Japan (-0.1), Sweden (-0.1), Germany (0).

So who's right?

Well, Nouriel Roubini writes:

In the medium-term, deflationary pressures will most likely outweigh inflationary pressures...

• In the medium-term, money supply increases alone will not arise in inflation. Inflation from CE and QE is unlikely until credit growth picks up. The money supply has grown, but the velocity of money slowed. Private sector lenders are not making loans even though their reserves have increased. "Printing money doesn't cause inflation unless that money reaches consumers" ... The fall in the supply of loans and demand for borrowing has collapsed the money multiplier. The Fed's efforts have slowed but not fully offset the contraction in demand for broad money. Deleveraging has lowered debt demand and increased demand for cash-like instruments. Furthermore, the deflationary headwinds from a contracting U.S. and global economy - falling employment and income, decline in aggregate demand, asset devaluations, lower commodity prices, slowing production - will keep a lid on U.S. inflation in 2009.

And Pimco, the world's largest bond fund, also thinks that the fears of near-term inflation are unwarranted. As Bloomberg writes:

[Pimco] said the economic outlook “looks bad” for most of the world and central banks will refrain from raising interest rates.

“Rate hikes will be some time in coming,” Andrew Balls, a managing director for the company in London, wrote in a report on the company’s Web site.

Signs of recovery in economies around the globe point to a slower pace of decline rather than recovery, Balls wrote. The outlook over the next three to five years is for “weaker global growth and especially weaker growth in the developed countries,” he said.

Pimco’s view echoes those of the Wall Street firms that trade directly with the Federal Reserve, who say bets on higher interest rates will turn out to be wrong. Fifteen of the 16 so- called primary dealers surveyed by Bloomberg News said they don’t expect the central bank to raise the target rate for overnight loans between banks this year.

Higher interest rates would be a sign, of course, that the economy is recovering and that there is too much money in the system, and is a way to try to brake inflation.

While Bloomberg notes that "Traders see a 62 percent chance the Fed will raise its target rate by its November meeting, based on futures on the Chicago Board of Trade. The odds were 26 percent a week ago", I'm not sure that the traders have more insight on the issue that the experts.

It is also important to remember that this debate is not occurring in a vacuum. The government's actions - especially buying Treasuries - powerfully affects whether we move to inflation or continued deflation.

As Rob Parenteau notes:

If central banks step in to buy Treasuries and thereby contain the back up in Treasury yields, more professional investors are likely to conclude “monetization” is underway and they will try to increase their exposure to inflation hedges. The net result would be a likely rise in the relative prices of energy, precious and industrial metals, “commodity” currencies, and ag products and ag land – all of which, as inputs to final products, would tend to represent an adverse supply shock to the economy.

Finally, it is important to remember that investor and consumer psychology is a driver of inflation or deflation. As the Washington Post's Robert Samuelson writes:

The lesson for today: Psychology matters. What economists call "expectations" shape how workers, managers and investors behave. If they fear inflation, they act in ways that bring it about. The converse is also true, as the late 1940s remind. The lesson provides context for today's debate. Are the Federal Reserve's easy-money policies laying the groundwork for higher inflation? Or will these policies prevent deflation -- a broad decline of prices -- that would deepen the economic slump?

The questions arise from the Fed's strenuous efforts to contain the economic crisis. It has cut the overnight Fed funds rate almost to zero. It has made loans when private lenders wouldn't -- in the commercial paper market, for instance. To lower long-term interest rates, it has pledged to buy $1.25 trillion of mortgage securities backed by Fannie Mae and Freddie Mac and $300 billion of long-term Treasury bonds. All these measures are without modern precedent.

Precisely, say the inflation worriers. Once the economy recovers, the easy money and credit will spawn inflation. Cheap loans will bid up prices; wages may follow. Low interest rates will encourage spending and deter saving. The Fed will be "under pressure from Congress, the administration and business . . . to prevent interest rates from increasing," warns economist Allan Meltzer of Carnegie Mellon University. With huge budget deficits, the White House and Congress will want to hold down borrowing costs. Inflation psychology will emerge.

Nonsense, say deflation worriers. Inflation results mainly from too much demand chasing too little supply. Today, too much supply chases too little demand. High unemployment and slack business capacity (idle factories, vacant office suites, closed mines) impede wage and price increases. If the Fed doesn't maintain cheap credit, shrinking demand might cause prices and wages to spiral down. "Deflation, not inflation, is the clear and present danger," retorts Princeton economist and New York Times columnist Paul Krugman.

It seems impossible for both arguments to be correct, but they may be. ... Inflationary expectations are low.

All this gives the Fed maneuvering room. Expectations matter; inflation won't burst forth instantly. Even Meltzer doesn't see an immediate surge. "When will it come? Surely not right away," he writes.

Summers, Geithner, Bernanke and the other meatheads at the helm are trying to re-inflate the bubble as quickly as possible, and to trick consumers into thinking everything is just dandy.

Will consumers buy the whole "green shoots" con game, which could lead to inflation? We will have to wait and see . . .

Remember that it is also possible for some classes of assets to inflate while others simultaneously deflate.

And see this.

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