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The Truth About Deflation

“We are on the eve of a deflationary shock which will likely reduce equity valuations from very high to very low levels…..it is increasingly likely that one event will be the catalyst to very rapidly change inflationary into deflationary expectations. Indeed, when key prices are already falling across the globe, one should expect one key major credit event to occur.” Russell Napier, “An Ill Wind”, CLSA, selected excerpts, zero hedge.

Deflationary pressures are greater today than anytime since the end of the recession in March 2009.

In September 2011 the annual rate of inflation was 3.9 percent. At present, the rate is just 1.0 percent and trending lower. Inflation has continued to fall despite five years of zero interest rates and 3 rounds of quantitative easing. For all practical purposes, the Fed’s large-scale asset purchases (LSAP) have had no impact on inflation at all, in fact, some analysts believe the Fed’s polices may be counterproductive. Take a look at this from Stephen Williamson’s New Monetarist Economics blog:

“Back in days of yore, my concern was that we could indeed get higher inflation. How? I had thought that the Fed had the ability to control inflation, but when push came to shove, they wouldn’t do it. Once people caught on to that idea, we could get on a high-inflation path that was self-sustaining. Of course, since I said that, I’ve continued to work on these problems, and stuff has been happening. In particular, we’re not seeing that high-inflation path. How come?…

…with the nominal interest rate effectively at the zero lower bound, the rate of inflation is being determined primarily by the liquidity premium on government debt. Once we recognize that, it’s not surprising that the inflation rate has been falling for the last three years…

…In general, if we think that inflation is being driven by the liquidity premium on government debt at the zero lower bound, then if the Fed keeps the interest rate on reserves where it is for an extended period of time, we should expect less inflation rather than more…

The Fed is stuck. It is committed to a future path for policy, and going back on that policy would require that people at the top absorb some new ideas, and maybe eat some crow. Not likely to happen.” (“Liquidity Premia and the Monetary Policy Trap“, Stephen Williamson, New Monetarist Economics blog):


Williamson is not alone in his belief that the Fed is on the wrong track. Economist Warren Mosler arrives at the same conclusion although there are notable differences in their analysis. Here’s a short clip from an article by Mosler which wraps it up in one paragraph:

“Theory and evidence tell me it’s impossible for the Fed to create inflation, no matter how much it tries. The reason is because all the Fed does is shift dollars from one type of account to another, never changing the net financial assets held by the economy. Changing interest rates only shifts dollars between ‘savers’ and ‘borrowers’ and QE only shifts dollars from securities accounts to reserve accounts. And so theory and evidence tells us not to expect much change in the macro economy from these primary Fed tools, making it impossible for the Fed to create inflation.” (“It must be impossible for the Fed to create inflation“, Warren Mosler, Huffington Post)

The Fed is stuck in an ideological cul de sac mainly because its members ascribe to Bernanke’s monetary theories which simply don’t work. Here’s a clip from a speech the Fed chairman gave to the National Economists Club in 2002 that gives us a glimpse into his thinking:

“Under a fiat money system, a government… should always be able to generate increased nominal spending and inflation, even when the short-term nominal interest rate is at zero.” Ben S. Bernanke, “Deflation: Making Sure It Doesn’t Happen Here”, Federal Reserve, November, 2002

Okay, so where’s the inflation, Ben? The Fed’s 2 percent inflation target continues to move farther away the longer the Fed’s programs stay in place. Even more shocking is the fact that “The Fed’s preferred measure of U.S. inflation, the personal consumption expenditures deflator (PCE), showed last week that prices rose 0.7 percent in October, the least since 2009.” (Bloomberg) So even by the Fed’s own standards, QE and zirp have been a bust.

The reason for this is simple: QE does not raise inflation because QE does not increase incomes, wages or credit. The reserves that are created via QE remain in the banking system where they buoy asset prices by reducing the supply of stocks and bonds available for sale. But there is no transmission mechanism for delivering money to the real economy where it can increase activity, inflation and growth. The fact is, QE may actually be deflationary since it reduces the interest on bonds (US Treasuries) that provide income for savers and other fixed-income investors. Some analysts put the amount of potential savings lost due to QE in the neighborhood of $400 billion, which represents about half of all the money spent on Obama’s fiscal stimulus called the American Recovery and Reinvestment Act of 2009. Naturally, the loss of this revenue has only added to the sluggishness and stagnation of the US economy.

Economist Frances Coppola believes that QE is “deflationary rather than inflationary”, and makes the case in a recent post on her blog titled “Inflation, Deflation and QE”:

“Both UK and US governments believe that monetary tools such as QE can offset the contractionary impact of fiscal tightening. But this is wrong. Fiscal tightening principally affects those who live on earned income. QE supports asset prices, but it does nothing to support incomes. So QE cannot possibly offset the effects of fiscal tightening in the lives of ordinary working people – the largest part of the population. In fact because it seems to discourage productive corporate investment, it may even reinforce downwards pressure on real incomes. And when the real incomes of most people fall, so does demand for goods and services, which puts downward pressure on prices, driving companies to reduce costs by cutting hours, wages and jobs. This form of deflation is a vicious feedback loop between incomes, sales and consumer prices, which in my view propping up asset prices can do little to prevent.” (“Inflation, Deflation and QE”, Frances Coppola, Coppola Comment)

Coppola, who calls QE “one of the biggest policy mistakes in history,” backs up her claim with a number of charts and graphs which show how inflation fell during periods when central banks were buying sovereign bonds and boosting reserves at the banks. (Remember, the point of QE is to raise inflation expectations, not lower them.) Her repudiation of QE is further underscored by the fact that the so called “velocity of money” has dropped to a six decade low. Get a load of this graph from the St Louis Fed:


According to Investopedia the “velocity of money” means: “The rate at which money is exchanged from one transaction to another, and how much a unit of currency is used in a given period of time…Velocity is important for measuring the rate at which money in circulation is used for purchasing goods and services. This helps investors gauge how robust the economy is, and is a key input in the determination of an economy’s inflation calculation.”

Bernanke knows that velocity is in the doldrums and that QE has had no meaningful impact on activity. Keep in mind, these are the Fed’s own charts. All the members of the FOMC are familiar with them and know what they mean. And what they mean is that the money is going no where; it’s stuck in the financial system goosing asset prices and providing needed balm for bloody bank balance sheets which are still deep in the red five years after Lehman Brothers collapsed. In other words, QE is working largely as it was designed to work. It is boosting profits for the financial sector while keeping the real economy in a permanent slump. As long as the economy underperforms, the Fed will have a reason to continue the existing policy. If, however, the economy gains momentum and inflation rises, the Fed will be forced to wind down its asset purchases and raise rates cutting off the flow of interest-free money to the banks. Thus, the Fed’s strategy requires that the US Congress and the White House continue to shave the deficits, curtail public spending and implement other belt-tightening measures to make sure the economy does not rebound and upset the Fed’s plan to continue its wealth transfer to Wall Street.

This sounds easier than it is, in fact, the droopy rate of inflation suggests that Bernanke may already be too close to the cliff-edge to pull back in time. Credit growth, personal consumption, wages and incomes remain either flat or trending lower. The recent bump in Third Quarter (3Q) GDP was largely due to one-time inventory buildup that will undoubtedly weigh heavily on future readings. The same rule applies to unemployment where the uptick in payrolls is overshadowed the bleak participation rate which continues to reflect the abysmal state of the labor market. Also, the New York Fed just released a report (FRBNY Survey of Consumer Expectations: Household Finance Expectations) showing that “both household income growth and spending expectations are basically flat-lined (and) that there is no expectation of things getting any better or any worse.” (Housingwire) Needless to say, when consumers are as pessimistic as they are today, it greatly impacts their spending habits. (which the survey confirms)

Finally, the US economy is bound to be wacked by Japan’s accelerated QE program which has slashed the value of the yen weakening US exports while pushing up the value of the dollar. Like the Fed, the Bank of Japan is following a beggar-thy-neighbor policy which exports deflation to its trading partners in the relentless pursuit of aggregate demand. This is how currency wars start.

All of these are adding tinder to a woodpile that could burst into flames in 2014. CLSA’s prescient analyst, Russell Napier, believes the world is about to experience a “deflationary shock” that will send raw materials, manufactured goods, and stocks plunging. Here’s a short excerpt from his article titled “An Ill Wind” via zero hedge:

“Three times since 1997 inflation has fallen below 1% with very negative impacts for equity investors. On all three occasions an existing low level of inflation was forced lower by dramatic events: the bankruptcy of Russia and collapse of LTCM in 1998; the terrorist attacks of 11 September 2001; and the bankruptcy of Lehman Brothers in September 2008. While nobody would attribute the 11 September atrocity with extant global deflationary forces, the other two episodes can clearly be associated with such forces. So perhaps it is global deflationary forces creating a bankruptcy event, somewhere in the world, that is the catalyst for a sudden change in inflationary expectations in the developed world. It can all happen very quickly; and it is dangerous to stay at an equity party driven by disinflation when it can spill so rapidly into deflation.

In 1998 falling export prices triggered a Russian default, and in 2008 falling US house prices triggered the Lehman bankruptcy. Going back further, deflation in the oil price in 1982 produced a Mexican default and a credit event which threatened to bring down the US banking system. Deflation in these key prices produced a credit event which rapidly produced a major reassessment of the outlook for the general price level. Across the world today we see falling commodity prices and, primarily due to the weak yen, falling manufactured-goods prices. When there is plenty of leverage in the system and any key price starts to decline then a credit event and a sudden change in inflationary expectations are much more possible than the consensus believes.” ( “An Ill Wind”, Russell Napier, CLSA, selected excerpts, zero hedge)

The threat of deflation is quite real, in fact, it’s probably just one bank failure away.

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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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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