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Deflation is Right Around the Corner

In June, the Fed’s bond-buying binge (QE2) will end and the economy will have to muddle through on its own. And, that won’t be easy, because QE2 provided a $600 billion drip-feed to ailing markets which helped to lift the S&P 500 12 per cent from the time the program kicked off in November 2010. Absent the additional monetary easing, the big banks and brokerages will face a chilly investment climate where belt-tightening and hair shirts are all the rage. There’s a good chance that stocks will fall sharply and that the tremors on Wall Street will ripple through the broader economy, further crimping the credit expansion and leading to a slowdown in personal consumption.  As activity drops off, commodity prices will plunge and the telltale signs of deflation will reappear. So, the end of QE2 could be a tipping point, where the recovery strengthens and gains momentum or where the inertia of the underlying economy becomes more apparent and we backslide into negative growth.

Inflation is not the issue. In fact, Fed chairman Ben Bernanke has been doing everything in his power to create inflation, but with little success. Core inflation is still stuck at 1 per cent due to high unemployment and stagnant wages. If wages stay flat, then food and gas prices will eventually fall as demand erodes. It’s simple, really; when the paycheck runs out, the spending stops. End of story. Speculators don’t see it that way. They think the party can go forever, but they’re mistaken.  The commodities’ day of reckoning is fast approaching and it’s likely to be a bloodbath.  Here’s a clip from a post by Tim Duy which explains why soaring gas and food prices are not really signs of inflation:

“Inflation is not a general increase in prices. That is a one-time price increase, or a shift in relative prices. Inflation is a continuous increase in the price level, which, to be perpetuated, needs to be matched by increasing wages….  Without an increase in wages, the current gains in headline inflation will prove to be transitory.” (“Misguided Meltzer”, Tim Duy, Fed Watch)

Bingo. And wages are not increasing, so you can bet the higher gas and food prices are just a temporary blip on the radar. The United States is not headed for hyperinflation; that’s nonsense. The country is in a Depression. If the Fed hadn’t pegged rates below the current rate of inflation, then the economy would still be contracting today. But zero rates and lavish monetary accommodation have kept the ship aright. Still, that doesn’t change the fact that we’re still mired in a very deep slump.

Consider this: The Fed Funds rate is currently 0.25 per cent while the rate of inflation is roughly 1 per cent, so the Fed is losing money on every dollar it lends, right?

So, let’s say that I manufacture bicycles, and every bike costs me $225 for parts and labor. But the market for new bikes is soft, so I decide to sell my bikes for $150 each. How long do you think I’d stay in business?

On the other hand, if I was the Fed, lending money at a net-loss while providing a direct subsidy to the banks that borrow from me, I would not only be rewarded for my incompetence by being appointed chief regulator of the entire financial system, but I’d also be able to boast that I’d sparked a “self-sustaining recovery”. How crazy is that?

 Even so, the Fed is right about inflation. Here’s an excerpt from the Fed’s Open Market Committee’s minutes last week:

“Participants expected that the boost to headline inflation from recent increases in energy and other commodity prices would be transitory and that underlying inflation trends would be little affected as long as commodity prices did not continue to rise rapidly and longer-term inflation expectations remained stable….

“ …the relevant point is that… despite an increase in expected inflation for this year, longer-term expectations remain either within or very close to a historical range that can be considered normal….”

See? Inflation is not a problem.  Commodities prices will fall as soon as QE2 ends and deflationary pressures reemerge. Here’s how economist David Rosenberg sums it up over at The Big Picture:

“…it remains a legitimate question as to how we end up with inflation as credit contracts.  Not just in the consumer and housing sectors, but in the government sector too. The state and local government sectors have dramatically cut back on bond issuance this year and are canceling capital projects in the process. We see on the front page of the weekend WSJ this headline ? Inflation Drives a Shift in Markets and right above it is Deadline Drama Over Budget. Not only is household credit contracting, but the same is happening at the government level. This is deflationary, not inflationary, and once commodities settle down … all this talk of inflation is going to subside pretty quickly.”

 And, as for the Fed’s bond buying program, Rosenberg adds this:

“Fully 100 per cent of both QEs by the Fed merely was new money printing that ended up sitting idly on commercial bank balance sheets. Money velocity and the money multiplier are stagnant at best……(“Fade the Inflation Hysteria”, David Rosenberg chief economist Gluskin Sheff, The Big Picture)

QE2 has been a bust and the massive bank reserves pose little immediate threat of inflation. The greater danger is another shock to the system that would expose the vast amount of red ink that’s being hidden on banks balance sheets. That would put the deflationary dominoes back in play and thrust the financial system back into crisis.  For example, here’s a tidbit you may have missed in the recent news:

“Bank of America Corp. (BAC), the biggest U.S. lender by assets, is segregating almost half its 13.9 million mortgages into a “bad” bank comprised of its riskiest and worst-performing “legacy” loans, said Terry Laughlin, who is running the new unit.

“We are creating a classic good bank, bad bank structure,” Laughlin told investors at a meeting in New York today….The legacy portfolio will hold 6.7 million loans with outstanding principal balance of about $1 trillion, according to a presentation to investors today. The split leaves home loan President Barbara Desoer with about half her previous portfolio, as well as new lending going forward.” (“BofA Segregates Almost Half of its Mortgages Into ‘Bad Bank'”, Bloomberg)

Got that?  B of A is lashed to a $1 trillion pile of garbage that no one even knew about until just recently. How’s that for transparency?  And that’s just one bank. Imagine how many trillions more lurk behind the accounting chicanery of the other Wall Street giants. It’s mindboggling. There’s a big enough capital-hole in the US banking system to swallow an entire galaxy and then some.

And what does this say about our new “reformed” regulatory system? Is the FDIC really going to let this charade to go on without firing current management, taking the bank into conservatorship, ring-fencing the toxic loans, and hosing down the whole operation. Has nothing changed?

The losses at the banks are hugely deflationary. When hundreds of billions of dollars vanish from the system in a poof of smoke; the system shrinks, prices fall, lending sputters, the dollar strengthens, and the true burden of debt increases. Deflation, deflation, deflation and deflation. And, while its true, that the Fed has transferred a lot of the losses onto its own balance sheet; that can’t go on forever. The announcement from B of A suggests that the banks will be expected to clean up their own books from now on and manage their own losses. Good luck with that!

And the banks are not the only place where deflationary pressures are building. Get a load of this in the Wall Street Journal:

“The U.S. has a whole lot more spare capacity – in terms of unemployment workers, idle factories, empty offices and stores – than Europe. (And) The larger the output gap, the theory goes, the less likely inflationary pressures are to emerge.

Economists at Goldman Sachs… say: ‘The output gap is larger in the US (at around 6 per cent of GDP) than it is in the Euro-zone, Japan and the UK (each between 3 per cent and 4 per cent of GDP).’

“Reflecting our view that potential output growth has been largely unaffected by the crisis, we expect output gaps to close only gradually.” (“Mind the output gap”, David Wessel, Wall Street Journal)

Bottom line: If there’s a lot slack in the economy, inflation can’t take hold.

So, yes, commodity prices can rise when there’s excess capacity, but not for long. Eventually, prices fall back to earth. Recently, oil shot up to $108 a barrel, pushing regular unleaded gas up above $4 in places like California. The high prices have forced consumers to divert money from other purchases like clothes or vacations. So aggregate spending is not increasing, consumers are merely cutting back in one area to meet rising expenses in another. This situation will inevitably slow growth and prolong the downturn.

Low bond yields are also signaling deflation. Why would an investor purchase a 10-year Treasury bill for a measly 3.5 per cent if he thought inflation was going to be galloping ahead at a double-digit clip? He wouldn’t; he put it somewhere where he thought he’d get a better return. This is from Reuters:

“With time rapidly running out before the debt ceiling is reached, and doom-mongering rampant about the disastrous possible consequences of the US Treasury being unable to repay its debts, just look what’s happened to the market in short-term Treasury bills!

The lack of supply was so severe on Monday, and some investors so desperate for Treasuries, that they accepted negative yields. That is something that has rarely been seen since the financial crisis.

In other words, the market simply isn’t worried about short-term US debt at all. Instead, Treasuries are rallying….”(“The unexpected T-bill rally”, Felix Salmon, Reuters)

If investors are worried about inflation, it’s not apparent in the bond market. Sales are quite brisk and the low yields mean that investors are still unwilling to abandon risk-free assets. In other words, Bernanke’s bond purchasing program has done nothing to “buck up” confidence or reduce investor uncertainty. People are as scared now as they were when Lehman flopped.

And what about those falling house prices: Inflationary or deflationary?

Falling housing prices will bear down hard on household balance sheets and personal consumption. That’s deflation. And, the official figures don’t even account for the magnitude of the damage because the CPI does not accurately reflect home prices but “owners’ equivalent rent” (OER), a goofy gauge of what it would cost to rent a home, not buy one. This is why spiking home prices failed to alert policymakers to the danger of skyrocketing inflation during the bubble years, because their gauges were giving-off bogus readings. Unfortunately, the Bureau of Labor Statistics is now making the same mistake in reverse which will lead to a whole new set of problems. Here’s an excerpt from Floyd Norris at the New York Times who explains what’s going on:

“In 2004, when home prices were climbing at a rate of almost 10 percent a year – more than four times the increase in rents – the core index would have been over 5 percent had home prices been included. Instead, the reported core rate was just 2.2 percent….

“In the last few months, the two markets have again diverged, but in the opposite way.

“From October 2010 through January, home prices as measured by an index kept by Federal Housing Finance Agency fell at an annual rate of 12.4 percent, while the government’s calculation of owners’ equivalent rent shows it rising at an annual rate of 1.5 percent….

“Inflation rates may have been understated for years when home prices were rising much more rapidly than rental rates….(But) Now, it is possible that inflation will be overstated precisely because speculative excesses are being purged from the housing market.” (“If Home Prices Counted in Inflation”, Floyd Norris, New York Times)

Indeed, if inflation is being “overstated”, (because the instruments for calculating inflation are flawed) then the Fed should be cranking up the stimulus to make up the difference so the economy doesn’t shrink. As housing prices fall and debts are unwound, more liquidity will drain from the system and the economy will start to sputter. The problem will only get worse until housing hits bottom.

Also, the Fed’s attempts to weaken the dollar (to make US exports more competitive) have met with stiff resistance from trading partners. They don’t like the idea that Bernanke has unilaterally fired up the printing presses and flooded their markets with hot money seeking a higher return. So, now they are retaliating to keep their currencies weak and to protect their labor markets.  It all has the makings of a full-blown currency war. This is from the Wall Street Journal:

“Central banks in South Korea, Malaysia and Indonesia appeared to intervene in the foreign-exchange market Monday, continuing the fight to slow the rise in their currencies as better risk appetite bolsters purchases of the region’s assets.

“Big trade surpluses, world-beating economic growth and low interest rates in the U.S. and Europe have pushed a wall of capital into Asia-Pacific economies, driving up currencies to levels that worry the authorities in many export-reliant economies.

 “Several central banks responded in recent weeks by selling their currencies for dollars in a bid to tame the rises and keep their economies competitive with those of their neighbors. They are looking over their shoulders at China, where a tightly contained rise in the yuan is putting other Asian exporters at a competitive disadvantage.

“South Korea, Malaysia and Thailand appeared to intervene Thursday, while banks thought to be agents of the Monetary Authority of Singapore have also been seen selling the Singapore dollar.” (“Asian Central Banks Aim to Weaken Currencies”, Wall Street Journal)

If the currency war continues, the Fed’s efforts to weaken the dollar will be canceled out by the interventions of foreign central banks. In other words, QE2 will have achieved nothing.

Another telling sign of deflation is the steadily dimming revenue picture of the giant Wall Street banks and brokerages. While profits are still at record highs,  revenues continue to shrink. In other words, the pie is getting smaller. Cutbacks and layoffs can improve earnings in the short-run, but eventually the whole operation begins to shrivel and the industry goes into decline. And, that’s what’s happening right now.  This is from Bloomberg:

“A surge in market volatility following Japan’s worst earthquake on record and a jump in oil prices may not be enough to keep investment-banking and trading revenue from falling for a fourth consecutive quarter.

“Analysts have lowered first-quarter earnings estimates at the biggest U.S. banks, saying trading revenue won’t rebound as much as they had expected from a weak fourth quarter. The outlook for the period fuels speculation that Wall Street is facing a prolonged decline in investment-banking and trading revenue after record figures in 2009….

 “Total investment-banking and trading revenue at the five banks may drop 25 per cent from the first quarter of 2010, according to estimates by Chris Kotowski, an analyst at Oppenheimer & Co. in New York….

 ‘“ ‘In the aftermath of the financial crisis, you’re going to have a sustained period of uncertainty in the market,’ Staite said. ‘So you could argue that it’s at least a semi-permanent decline in revenue.’” (“Wall Street Trading Revenue Seen Falling 4th Straight Quarter”, Bloomberg)

Staite is right to focus on the “uncertainty in the market” as the cause of the decline in revenue. Investors are as jumpy as ever and Bernanke has done nothing to calm the markets or restore confidence. And, Congress hasn’t helped out either. They’re more concerned about trimming deficits and cutting costs then rebuilding the economy and putting people back to work.

So, who’s going to invest in this environment? Who’s going to bet on a rosy future of bulging sales and strong demand when they know that the government is going on an austerity-binge, liquidity is drying up, and the Fed is pulling the plug on its emergency bond buying program?

That’s why the end of June could be the tipping point, because when QE2 ends, deflationary pressures will reemerge and the economy will begin to teeter.

Eventually policymakers will see that fiscal stimulus is the only way to lift the economy out of its funk, but only after they have exhausted all the other options.

MIKE WHITNEY lives in Washington state. He can be reached at fergiewhitney@msn.com

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MIKE WHITNEY lives in Washington state. He is a contributor to Hopeless: Barack Obama and the Politics of Illusion (AK Press). Hopeless is also available in a Kindle edition. He can be reached at fergiewhitney@msn.com.

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