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Where's the
deflation?
Here is an extract from commentary
that was posted at www.speculative-investor.com on 5th December 2002.
If we define deflation correctly, that
is, if we define it as a decrease in the total supply of money and credit,
then there clearly isn't any deflation. The total US money supply has been
growing at a rapid rate for several years and has risen by around 7% over
the past 12 months. There is, though, a legitimate concern that the massive
debt burdens being carried by US consumers and corporations, plus the huge
over-capacity in some sectors of the economy (the telecommunications industry
being a prime example), plus the wobbling economic recovery, will lead
to more defaults and bankruptcies. Contrary to popular opinion a debt default
doesn't result in a decrease in the supply of money (when someone defaults
on a debt the lender's net worth takes a hit, but the money that was originally
loaned still exists somewhere in the economy). However, if defaults are
widespread and sizeable then the ability and the desire of lenders to make
additional loans will diminish. As such, widespread debt defaults will
likely, at some point in the future, lead to less lending/borrowing and
therefore slower money supply growth (or perhaps even money supply contraction,
that is, genuine deflation). But, it is blatantly obvious that we haven't
yet reached that point because the total supply of US dollars grew at an
annualised rate of around 15% over the most recent 2-month period. Furthermore,
with the Fed having recently proclaimed its willingness to monetise anything
and everything in order to devalue the dollar by increasing its supply
should prices start to fall, the possibility of the US experiencing deflation
at any time over the next 12 months is remote. Actually, there isn't much
chance that the US will experience deflation between now and when
inflation
is perceived to be an enormous problem (once the financial markets start
to discount a high US$ inflation rate the Fed will no longer be free to
inflate to its heart's content).
Even if we define deflation incorrectly,
that is, even if we accept the government-sponsored definition that deflation
is a reduction in the price of some arbitrarily-selected hedonically-adjusted
basket of goods and services, there still isn't any deflation. The CPI
has risen at an annualised rate of 2.7% since the beginning of this year
and is likely to finish the year with a gain of around 3%. Of course, if
we remove some of the more troublesome items (the ones that have gone up
in price the most) from our basket of goods and services, as is the common
ploy, we would end up with a lower positive number (in the same way that
the S&P500 Index would be lower if we decided to omit some of the best-performing
stocks from its calculation). But where's the logic in that?
Prices have risen this year, but what
about next year? Well, according to the Future Inflation Gauge calculated
by the Economic Cycle Research Institute (http://www.speculative-investor.com/FIG_fed.htm)
next year's increase in the CPI is going to be greater than this year's.
So, where's the deflation?
The Fed, by the way, has recently signaled
its intention to fight a fall in prices, not its intention to fight
deflation. An effect of deflation is lower prices, but prices can fall
for reasons other than deflation. For example, becoming more productive
or importing more cheap products from China would put downward pressure
on prices, but these price suppressants have nothing to do with deflation.
However, regardless of what causes prices to fall (assuming they
fall at all, which we seriously doubt), the Fed has threatened to offset
any fall in the general price level by depreciating the US$. This
is not an empty threat since the Fed has the power to make the US$ so worthless
that it ceases to circulate as currency. Clearly, the Fed will want to
stop the devaluation well before the US$ becomes completely worthless.
With the Fed having recently come out
so strongly against deflation and reminded us of its enormous power in
the field of currency depreciation, when the effects of inflation become
more obvious (as they no doubt will over the coming 12 months) will the
Fed be congratulated for having saved us from the deflation bogey? Will
Alan Greenspan receive a medal of honor, to go with his knighthood, as
a tribute to his courageous efforts in what will almost certainly appear
to be a very successful war against deflation? If so, it really would be
a public relations coup on his part because the leader of a major central
bank has never before been commended for destroying the purchasing power
of the national currency.
Finally, the Fed's threat to devalue
the dollar might not be an empty one, but its threat to peg long-term interest
rates at artificially-low levels is (in recent speeches both Fed Governor
Bernanke and Fed Chairman Greenspan have mentioned the possibility of the
Fed buying whatever amount of long-term debt it needed to buy to keep long-term
interest rates at some pre-determined low level). If the US$ was being
devalued and the Fed had committed to keep the yields on 10-year bonds
from rising above, say, 2%, who else besides the Fed would be a buyer of
bonds? Anyone who bought bonds under such circumstances would be accepting
a guaranteed loss, in real terms. If the Fed decided to peg long-term interest
rates well below levels that would otherwise be set by the market then
there would be a mass exodus from the US credit markets and a collapse
in the US dollar's exchange rate. Unless, of course, all the other major
central banks were implementing a similar strategy in which case there
would be panic buying of gold and other hard assets.
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