Submitted by Leo Kolivakis, publisher of Pension Pulse.
I want to follow-up on my last comment on the “W” recovery because it is absolutely critical for policymakers and investors to understand the arguments on both sides of the inflation/ deflation debate. I will make this post considerably shorter than the previous one, but there is plenty to cover.
First, we begin by looking at the latest quarterly review by Van R. Hoisington and Lacy H. Hunt of Hoisington Investment Management.
[Note: Click here to view all previous comments and here for a profile of Hoisington Investment Management.]
Hoisington Investment Management offers one of the best quarterly economic reviews on the internet. Their latest quarterly comment focuses on inflation/ deflation. They begin by stating:
Over the next decade, the critical element in any investment portfolio will be the correct call regarding inflation or its antipode, deflation. Despite near term deflation risks, the overwhelming consensus view is that “sooner or later” inflation will inevitably return, probably with great momentum.
This inflationist view of the world seems to rely on two general propositions. First, the unprecedented increases in the Fed’s balance sheet are, by definition, inflationary. The Fed has to print money to restore health to the economy, but ultimately this process will result in a substantially higher general price level. Second, an unparalleled surge in federal government spending and massive deficits will stimulate economic activity. This will serve to reinforce the reflationary efforts of the Fed and lead to inflation.
These propositions are intuitively attractive. However, they are beguiling and do not stand the test of history or economic theory. As a consequence, betting on inflation as a portfolio strategy will be as bad a bet in the next decade as it has been over the disinflationary period of the past twenty years when Treasury bonds produced a higher total return than common stocks. This is a reminder that both stock and Treasury bond returns are sensitive to inflation, albeit with inverse results.
Does this get your attention? It certainly got mine. Let’s read on:
…, let’s assume for the moment that inflation rises immediately. With unemployment widespread, wages would seriously lag inflation. Thus, real household income would decline and truncate any potential gain in consumer spending.
….
Inflation will not commence until the Aggregate Demand (AD) Curve shifts outward sufficiently to reach the part of the Aggregate Supply (AS) curve that is upward sloping. The AS curve is perfectly elastic or horizontal when substantial excess capacity exists. Excess capacity causes firms to cut staff, wages and other costs. Since wage and benefit costs comprise about 70% of the cost of production, the AS curve will shift outward, meaning that prices will be lower at every level of AD.
Therefore, multiple outward shifts in the Aggregate Demand curve will be required before the economy encounters an upward sloping Aggregate Supply Curve thus creating higher price levels. In our opinion such a process will take well over a decade.
And on the record expansion of the Fed’s balance sheet:
In the past year, the Fed’s balance sheet, as measured by the monetary base, has nearly doubled from $826 billion last March to $1.64 trillion, and potentially larger increases are indicated for the future. The increases already posted are far above the range of historical experience. Many observers believe that this is the equivalent to printing money, and that it is only a matter of time until significant inflation erupts. They recall Milton Friedman’s famous quote that “inflation is always and everywhere a monetary phenomenon.”
[Note: On that last point, read Alan Meltzer’s New York Times op-ed article, Inflation Nation.]
These gigantic increases in the monetary base (or the Fed’s balance sheet) and M2, however, have not led to the creation of fresh credit or economic growth. The reason is that M2 is not determined by the monetary base alone, and GDP is not solely determined by M2. M2 is also determined by factors the Fed does not control. These include the public’s preference for checking accounts versus their preference for holding currency or time and saving deposits and the bank’s needs for excess reserves.
These factors, beyond the Fed’s control, determine what is known as the money multiplier. M2 is equal to the base times the money multiplier. Over the past year total reserves, now 50% of the monetary base, increased by about $736 billion, but excess reserves went up by nearly as much, or about $722 billion, causing the money multiplier to fall.
Thus, only $14 billion, or a paltry 1.9% of the massive increase of total reserves, was available to make loans and investments. Not surprisingly, from December to March, bank loans fell 5.4% annualized. Moreover, in the three months ended March, bank credit plus commercial paper posted a record decline.
On the surge of M2, Hoisington and Hunt write:
M2 has increased by over a 14% annual rate over the past six months, which is in the vicinity of past record growth rates. Liquidity creation or destruction, in the broadest sense, has two components. The first is influenced by the Fed and its allies in the banking system, and the second is outside the banking system in what is often referred to as the shadow banking system.
The equation of exchange (GDP equals M2 multiplied by the velocity of money or V) captures this relationship. The statement that all the Fed has to do is print money in order to restore prosperity is not substantiated by history or theory. An increase in the stock of money will only lead to a higher GDP if V, or velocity, is stable. V should be thought of conceptually rather than mechanically. If the stock of money is $1 trillion and total spending is $2 trillion, then V is 2. If spending rises to $3 trillion and M2 is unchanged, velocity then jumps to 3.
While V cannot be observed without utilizing GDP and M, this does not mean that the properties of V cannot be understood and analyzed. The historical record indicates that V may be likened to a symbiotic relationship of two variables. One is financial innovation and the other is the degree of leverage in the economy. Financial innovation and greater leverage go hand in hand, and during those times velocity is generally above its long-term average of 1.67 (Chart 4, above, click to enlarge).
Velocity was generally below this average when there was a reversal of failed financial innovation and deleveraging occurred. When innovation and increased leveraging transpired early in the 20th century, velocity was generally above the long term average. After 1928 velocity collapsed, and remained below the average until the early 1950s as the economy deleveraged.
From the early 1950s through 1980 velocity was relatively stable and never far from 1.67 since leverage was generally stable in an environment of tight financial regulation. Since 1980, velocity was well above 1.67, reflecting rapid financial innovation and substantially greater leverage. With those innovations having failed miserably, and with the burdensome side of leverage (i.e. falling asset prices and income streams, but debt remaining) so apparent, velocity is likely to fall well below 1.67 in the years to come, compared with a still high 1.77 in the fourth quarter of 2008.
Thus, as the shadow banking system continues to collapse, velocity should move well below its mean, greatly impairing the efficacy of monetary policy. This means that M2 growth will not necessarily be transferred into higher GDP. For example, in Q4 of 2008 annualized GDP fell 5.8% while M2 expanded by 15.7%. The same pattern appears likely in Q1 of this year
The highly ingenious monetary policy devices developed by the Bernanke Fed may prevent the calamitous events associated with the debt deflation of the Great Depression, but they do not restore the economy to health quickly or easily. The problem for the Fed is that it does not control velocity or the money created outside the banking system.
Washington policy makers are now moving to increase regulation of the banks and nonbank entities as well. This is seen as necessary as a result of the excessive and unwise innovations of the past ten or more years. Thus, the lesson of history offers a perverse twist to the conventional wisdom. Regulation should be the tightest when leverage is increasing rapidly, but lax in the face of deleveraging.
Hoisington and Hunt then discuss how massive increases in government debt will weaken the private economy,”thereby hindering rather than speeding the recovery.”
They end their quarterly review by stating that bonds still offer exceptional value:
Since the 1870s, three extended deflations have occurred–two in the U.S. from 1874-94 and from 1928 to 1941, and one in Japan from 1988 to 2008. All these deflations occurred in the aftermath of an extended period of “extreme over indebtedness,” a term originally used by Irving Fisher in his famous 1933 article, “The Debt-Deflation Theory of Great Depressions.”
Fisher argued that debt deflation controlled all, or nearly all, other economic variables. Although not mentioned by Fisher, the historical record indicates that the risk premium (the difference between the total return on stocks and Treasury bonds) is also apparently controlled by such circumstances. Since 1802, U.S. stocks returned 2.5% per annum more than Treasury bonds, but in deflations the risk premium was negative.
In the U.S. from 1874-94 and 1928-41, Treasury bonds returned 0.9% and 7% per annum, respectively, more than common stocks. In Japan’s recession from 1988-2008, Treasury bond returns exceeded those on common stocks by an even greater 8.4%. Thus, historically, risk taking has not been rewarded in deflation. The premier investment asset has been the long government bond (Table 1, below, click to enlarge).
This table also speaks to the impact of massive government deficit spending on stock and bond returns. In the U.S. from 1874-94, no significant fiscal policy response occurred. The negative consequences of the extreme over indebtedness were allowed to simply burn out over time. Discretionary monetary policy did not exist then since the U.S. was on the Gold Standard.
The risk premium was not nearly as negative in the late 19th century as it was in the U.S. from 1928-41 and in Japan from 1988-2008 when the government debt to GDP ratio more than tripled in both cases. In the U.S. 1874-94, at least stocks had a positive return of 4.4%. In the U.S. 1928-41 and in Japan in the past twenty years, stocks posted compound annual returns of negative 2.4% and 2.3%, respectively.
Therefore on a historical basis, U.S. Treasury bonds should maintain its position as the premier asset class as the U.S. economy struggles with declining asset prices, overindebtedness, declining income flows and slow growth.
Finally, the Financial Times’ view of the day asks, Is Inflation inevitable?:
There is a growing belief in financial markets that uncontrollable inflation is inevitable, but that view is wrong, argues Dominic Konstam, interest rate strategist at Credit Suisse.
Nor are we heading towards a prolonged depression and deflation, he believes.
“A more plausible scenario is a mildly deflationary middle way with positive nominal growth. We can think of this as Grandma Goldilocks,” he says.
This is a reference to the late 1990s, when market conditions were deemed just right – not too hot and not too cold – because real growth was high, but inflation low. “A decade later, Goldilocks may not be quite dead but just a lot older,” he says.
Mr Konstam believes growth is likely to be relatively subdued in the next few years, driven by fiscal stimulus, while real interest rates will remain high. He believes consumers will be spending less and saving more, exerting significant downside pressure on inflation. There will be plenty of excess capacity in the economy. “The output gap is very large and forewarns of downward pressure on prices to come,” he says.
What does this mean for financial markets? “If we’re right, [10-year Treasury] bond yields aren’t going to zero, but they’re going to stay low for a while. We’re not going to 4 per cent anytime soon. Stocks may not make new lows and they will surely be capped to the upside.”
My last two comments on the inflation/ deflation debate provide you with some of the forces shaping inflation expectations.
What will be the end result? Think about it as two huge tidal waves headed for each other. They might cancel each other out, but chances are that one will dominate the other and after reading Hoisington’s quarterly review, I have an eerie feeling deflation will swamp inflation.
If deflation does prevail, that spells trouble for pension funds that are heavily exposed to stocks and inflation-sensitive assets. They undertook a giant experiment that will likely end up costing future generations.
After reading this comment, do you still believe there is a bubble in bonds?
19 comments
Comments are closed.
Thanks for this detail for us deflationistas. We have to fill a $10T debt deflation hole. The fed can fill it, but this is highly unlikely. When I debate this point with people, there eyes glaze over at the mention of velocity of money, as if it were a fudge factor. But it is what happens when people are trying to protect wealth.
It just goes to show that liquidity is not the limiting factor. Solvency, of both banks and their customers, is the limiting factor now.
At the moment, they could probably increase the base money without limit. All that cash would just sit in the banks.
What they should do is print a lot of money, now that is seems to be possible to do so without adverse effects, and then set the reserve requirements to a whole lot higher level. That way we would have the system, when it finally recovers, on a healthy liquidity-constrained basis.
After that, they should let the markets handle the price of money, and focus instead on keeping the money supply aligned with the overall size of the economy.
Great post …
Looks to be a long road ahead …
I would also point out that each time a recovery seems to appear oil moves right up …I agree with the entire post but with the added caveat that a peak oil scenario is in play as well … If this scenario happens sooner rather than later the world will be looking at stagflation and further economic contraction … the exact consequences related to the size and duration of the spike in oil prices …
I think that at present inflation (upward spiraling increases in BOTH wages and prices) or deflation is ultimately a political dilemma, as either one can be engineered. However, inflation, while not good for anyone, would eat away the gains of the wealthy and asset holders that they have accumulated over the past several decades. The Fed and Treasury create enough money to replace money that have been created and lost by the banks. The banks are expected to earn their way out of the hole and presumably re-pay. But what does that mean “earn their way out”? It means extracting a pound of flesh from the population through high interest rates, commodity speculation, forcing companies into bankruptcies to collect on CDS. At the same time, the so-called “stimulus” amounted to roughly nothing: no investment in innovation and job creation and retention. On the latter point, we are being constantly warned of the dangers of protectionism. The wealth holders will not allow inflation to occur, the brunt of the recession will be born by the middle classes: the taxpayers, employees, borrowers, consumers and retirees. The next few years will feel and look like a twilight zone, like being a can.
Nobody knows. Accept that truth.
The Fed could induce inflation by printing billions and giving each American 1 million dollars. They will not and they will be extremely tentative with their QE because they are relying on creditors of the US keeping their good faith in the US bonds and currency. You can easily get out of control inflation by over doing the fiscal stimulus and racking up too much debt so that other countries start to take a dim view of your currency. There is a very good reason why the bank of England said to Gordon Brown, enough demonstrate how you are going to get your fiscal house in order and it is the same reason that the IMF is saying the same thing to the US.
At the moment the US does look like going toward deflation and there is little that the FED can do about those things outside of its control. There are however tipping points, triggered by either borrowing too much money or printing too much money that can flip things into an inflationary environment. The mistake that Hoisington Investment seems to be making is of looking at the US economy in isolation from the rest of the world. My worry is that the FED can not do enough to prevent deflation and congress will force the FED and Treasury to ratchet up their actions to such an extent that one of the tipping points will occur. Having a reserve currency means the US can do a lot more than other countries but the scope is not unlimited and testing those limits would most likely be unwise.
“Therefore, on an historical basis, US Treasuries should maintain its position as the premier asset class…”
Was the writer channeling Ben Bernanke? Isn’t US hubris stinking great?
Go right ahead, ‘deflationistas’, plough into US Treasuries while the market across the ocean in the UK mirrors the US failed market. Gordon Brown and Obama would be proud! What’s money? It will be worth more every day, right?
See Martin Hennecke, Tyche Investments, for some real commentary.
I agree with Brick. The US is not a closed system. If the dollar declines against external currencies then commodity prices feed directly into price inflation. Oil is the primary consideration.
Be wary about the “can’t have price inflation without wage inflation” argument. Zimbabwe recently printed their currency to destruction with unemployment at 80%. Wages was not enough of a brake on inflation there.
What is the rational to use M2 in the equation of exchange in the analysis? I suspect M2 accounts only for a fraction of all the credit money in the system. If using a much broader measure of money (What would be the right measure? All the credit created?) is more adequate and we enter a period of strong debt deflation, i.e. the amount of money in the system actually decreases, even if printed base money increases, a much larger increase in the velocity of money will be needed to compensate for the decrease in money and to trigger inflation.
rc
The Hoisington analysis seems to be based upon neo-classical economic thinking, which is not always valid. For example, in 1934 the inflation rate was a positive 3.5%, yet there was probably still substantial excess capacity. So comparing demand and supply does not always work.
The word velocity is defined in terms of two other variables. It is not an independent variable. All of that discussion section is an attempt to find meaning in what is just a definition. Typical of the weaknesses of neo-classical economics.
Major inflation could easily occur if the dollar were to drop substantially in value. We do not live in a closed economic system. There is no necessary conflict between inflation and unemployment and poverty. Consider events in some third world countries in recent decades, and the German experience after WWII.
Some inflationists argue that the increase in money supply will eventually lead to inflation, with a time lag of a few years that assumes some economic recovery first. The Hosington analysis also seems to ignore this time delay effect. Others have pointed out that inflation is sometimes a psychological rather then money phenomenon; it happens when people believe it will happen.
I still do not really understand money. I still have no opinion on whether inflation or deflation will develop, and the neo-classical analysis presented did not really help me.
Stephen,
The problem is that once deflation grips the U.S. and global economy, it is like a virus that constantly mutates and is very hard to cure.
The Fed knows this. They also know that deflation will wreak havoc on the banking sytem which is why they will keep rates extremely low for a very long time.
Importantly, the Fed would rather err on the side of inflation than risk getting mired in a deflationary spiral.
Some of you have commented that the U.S. is an open economy and that the U.S. dollar will tumble, thus causing inflation. Be careful here because currency movements are all about expected shifts in growth and real interest rates.
If traders expect the U.S. to lead global economic growth and higher rates to start in the U.S., then the greenback will slowly gain relative to other major currencies over the next few years.
Also, the Chinese will continue to fund the U.S. current account deficit as long as they have to. Their exports just plummeted and they need U.S. consumers to start consuming again.
But watch developments in China very closely because if they decelerate further, they might devalue their currency and flood the world with cheap goods again, which is deflationary.
Let’s not forget there are powerful deflationary forces out there: high consumer indebtedness, banks and shadow banks that are cutting leverage and lending, the internet, an ageing population in Europe and Japan and baby boomers in the U.S. who are increasingly worried about their retirement (and hence saving more).
And then there are mature pension funds that are shifting their asset allocation to buy more bonds.
All this to say that I am not convinced that inflation is inevitable and maybe the big surprise of the next decade will be how bonds outperform stocks.
Stay tuned, macroeconomics just got a whole lot more interesting!
Regards,
Leo
Leo,
> Stay tuned, macroeconomics just got a
> whole lot more interesting!
Now there's an understatement.
I used to think the words "Pension" and "Pulse" were diametrically opposed.
Now, they're Cliffhangers!
Great post.
Tim in Sugar Hill
P.S. I'm thinking of changing my moniker from Harlem Dad to Predatory Saver.
I am looking forward to selling my gold at $10,000 an ounce. :)
Failing that, I’m looking forward to buying a fancy condo on 5th Ave for 100k cash. :)
Vinny GOLDberg
Inflation helps stimulate growth and this is the heart of The Bernanke/Frankenstein Clone, i.e, if we inflate and ramp up prices, we can stimulate production, which will cause employment to increase, and thus robots, I mean people in our society will have jobs to help put food on their families.
As many will recall, output by producers increases when prices rise and thus it simply makes sense to help rocket gas prices back towards $5.00 per gallon and to help wheat and other basic foods shoot as high as possible, because this will be good for the global corporations that need to make profits to make up for the recent loss of several Trillions in bad bets they made at the unregulated casino.
Once we get these corporate engines back up and running at high speed, we can then encourage robots, I mean production workers to spend their capital on homes that will also need to increase in price, so that they wil have places to park their new SUVs, which allow them to buy $7.00 cups of coffee, and so on and so on.
I feel like Roubini here, but this too has passed, but I would like an opportunity to also add that in order for dividends to be increased at financial institutions, fees will have to increase and greater profit margins will need to be engaged, which will mean greater efficiency through the use of unregulated derivatives, i.e. global financial networks will have to pool resources to create scale and leverage to take over the world and to thus make sure that our robots are burdened by another tsunami wave of cheap and easy credit.
I need a plaster cast…
Therein lies the problem. History suggests that the FED will again be late to the game. Ask yourself, what are the odds that they will be able to pull the money out of the system before inflationgets out of control? Damned if they do and damned if they don’t but I believe they will take inflation over deflation any day of the week.
income velocity (Vi) is a contrived figure (Vi = Nominal GDP/M). The product of MVI is obviously nominal GDP. So where does that leave us? In an economic sea without a rudder or an anchor.
the "monetary base" is not a base for the expansion of money & credit
is inflation coming???? it is mathematically impossible to miss and economic forecast
economics deserves to be called the dismal science
Given that the Fed’s monetarist policies have failed, that quantitative easing went nowhere, what relevance is there to the real economy in equations based on monetary models?
I think we are already in a period of deflation. Its speed would be even greater than it is if the government were not trying insanely to re-inflate busted bubbles. BTW peak oil and supply-demand have nothing to do with the current rise in oil prices. This is the same speculative game we saw last year funded by taxpayer dollars going to BINO banks, like Goldman and Morgan Stanley.
I agree with those who say we need to look at the US economy as it fits into the world economy.
The article has a significant tell in that its only reference to indebtedness is to government debt. But it is really the overall high debt load not just the government but the whole country has that is the real killer.
Debt deflation may be what is happening now in some sectors but it hard to see how inflation more generally down the road is not going to be a significant part in how those debts are going to be dealt with.
Hugh,
I would be careful to claim outright that monetary policy and QE have totally failed. The effects typically show up with a lag of 6 to 12 months. However, you are right, deflation has already arrived in some asset classes like housing and the stock market, both way off their peaks.
Q1 foreclosures hit a record in the U.S., which is not supporting the thesis that housing has stabilized in any way, shape or form.
We need to see housing stabilize and unemployment stop creeping up before we can claim things have truly stabilized.
Will the U.S. inflate away its debts? They are sure trying hard but this is not going to be easy.
Meanwhile, let’s not forget that the shadow banking system is just a shell of what it used to be with significantly less leverage as both investment banks and hedge funds trim it down.
Deflation will roil private equity and commercial real estate. The only true hedge against deflation is government bonds.
I will say it again, if inflation does eventually become the problem, it could be particularly nasty, because governments will be far too slow and timid about taking the hard decisions needed to remove liquidity as aggressively as they are currently expanding it.
Regards,
Leo
the commodity index, adjusted for inflation is at a 200 year low. Let me say that again, the commodity index adjusted for inflation is at a 200 year low. Do people really think it will go lower?
Finished goods start with commodities as the basic inputs in many goods. Mines that take commodities out of the ground are coming up against cost constraints that the price isn’t supportive of further mining operations going forward. Already in gold you see declining mine production yearly due to the low price depressing exploration and development of new fields and the fields they do know of generally do not support development at current prices. This is occurring in other types of mines as well.
Time will tell who’s right on inflation. However, I do have my money where my belief is – 100% gold in etfs, miners, and physical.