Inflation or Deflation?

Mere mortal investors and their professional colleagues are (at least if they are honest and have a modicum of sense) a bit confounded as to what to do at this juncture. By all measures, inflationary pressures are gaining strength, and yet recessions lower aggregate demand and with it, price pressures. Ah, but what about the Chinese? Even if things get bad here, they aren’t fully in lock-step with the US economy and have plenty of firepower. And what happens when Helicopter Ben throws cash at the problem? Won’t lots of money creation debase the currency and by definition produce inflation?

It’s very easy to get a headache from this sort of thinking.

Michael Panzner offers a useful post, “The Wrong ‘Flation” on this topic, arguing for the deflationary outlook. The most powerful evidence for this view comes from the fact that the monetary authorities have lost control of credit generation (broader money, the old M3) as observers ranging from market mavens like Michael Shedlock to Serious Economists like Mohamed El-Erian have pointed out. The credit crisis means credit contraction, a process the Fed will likely be unable to staunch. That in turns points to deflation.

However, “unlikely” does not necessarily mean “unable”. Bernanke is a well known expert on the Great Depression, and well schooled in the dangers of letting contractionary processes feed on themselves. So he and his colleagues will be doing everything in their power from keeping a vicious circle from setting in. The Term Auction Facility was a creative measure that managed to stave off a crisis in the money markets. Perhaps he will be able to use a combination of novel measures, liquidity injections, and smoke and mirrors to keep confidence at a reasonable level (confidence and willingness to extend credit are what really is at risk here).

The problem, ultimately, is that credit extension (witness no-doc loans, mezzanine CDOs, speculative real estate lending, and “cov lite” LBO deals) went well beyond sustainable or sensible levels. There will need to be a reduction in credit, which will inevitably lead to a contraction. But what shape will that take? How far down is down? While I think a financial meltdown is a real possibility, I guesstimate the odds at 30%. That is dangerously high by any standards, but also says the greater likelihood is that a crisis will be averted.

While I am still generally pessimistic about the near-term prospects, the powers that be may be able to forestall a crisis (and by that I mean a credit crunch a la 1990-1991, not a real calamity) and instead engineer a fairly ugly recession (I’d prefer a short and very nasty one, but given the housing crisis, we are more likely to get a prolonged sluggish period). Not pretty, particularly for middle and lower middle income consumers, who will take the brunt of it, but the alternative (most likely a Japan-style deflation due to refusal to realize losses on inflated asset values) would be even worse.

From Panzner:

Those of us in the very small group that has correctly anticipated that past excesses would eventually come home to roost generally fall into two camps: the deflationists, who believe that another Great Depression is on the cards — at least initially — and the inflationists, who argue that hyperinflation — where prices spiral rapidly higher — is the most likely near-term outcome.

While there are more than a few reasons for the contrasting perspectives, in my view it largely comes down to a difference of opinion about how the U.S. reached the “tipping point” to begin with. That is, was it “printing presses” that fueled the housing and other bubbles, the malinvestment and imbalances, and the widespread belief in “something for nothing,” or was it excessive credit creation?

If the answer is the former, then the dollars that were and continue to be created remain in circulation, stoking inflationary expectations and exerting a relentless upward push on prices. As economists put it, there is too much money chasing too few goods.

If the answer is the latter — which is what I believe has been and is the case — then logic and history suggest that when the jig is finally up, it leads to relentless, liquidation-driven downward pressure on asset and other prices. As opposed to paper currency (or even digitally-created “money” that did not come about as a result of central bank buying and selling of government and other securities), much of the credit-money that was created out of thin air ends up “disappearing” (e.g., through default), diminishing overall demand.

In “Worried about Inflation? Just Wait,” Reuters columnist James Saft lends further weight to the deflationist perspective and puts paid to growing worries over rising commodity and consumer prices.

Never mind inflation, the powerful and long-lasting effects of the credit crisis will rein it in soon enough.

With oil, gold and other commodities at very high levels and U.S. producer prices up 6.3 percent last year — the most since 1981 — fears have risen that an aggressive round of rate cuts by the Federal Reserve will embed inflation.

Consumer price inflation for December was up 0.3 percent and has risen 4.1 percent since a year earlier.

But these are likely to prove lagging indicators, even if demand from emerging markets remains strong for raw materials.

If credit is being strictly rationed and asset prices falling — as they are in housing and in stocks — investment, consumption and just about anything else that can be put off will be put off.

“The strong probability is that we will get at least disinflation in 2008,” said George Magnus, senior economic advisor to UBS.

“I’m not aware of any banking crisis in history, almost without exception, that was not accompanied by falling inflation.

“When balance sheets are shrinking and credit restriction is being applied, the whole effect is to cause people either to not be able to make spending decisions or to defer them. It puts a downer on aggregate demand,” Magnus said.

A round of poor data, notably unexpectedly weak retail sales, prompted rumors of a highly unusual inter-meeting rate cut by the Federal Reserve, whose next scheduled meeting is January 29-30.

The Fed declined to comment. Traders were roughly evenly split on Wednesday in betting on a 50 basis point or a 75 basis point cut this month in the Fed benchmark, currently 4.25 percent.

But even aggressive cuts in interest rates will have a limited and painfully slow impact on demand under these circumstances, according to Magnus. He contrasts the current crisis, which is fundamentally about the solvency of borrowers and the banks that lent to them, with other crises, such as 9/11 or the stock market crash of 1987.

“When solvency is involved and asset prices are declining, monetary policy can help but can’t solve the problem.”

Yen carry trade and credit cards next?

Ominously for the economy, the Baltic Dry Index BADI of shipping capacity suffered its biggest one day drop since records began on Wednesday, down 5.74 percent and following similar heavy falls on Friday and Tuesday. The index is down almost 20 percent since January 1.

Because trade travels on ships, the Baltic index is often a good indicator of forward demand, both for natural resources and finished goods. Interestingly, the Baltic index continued to climb as the credit crisis unfolded through the summer, supported by strong economic growth in emerging markets.

Tim Lee of pi Economics in Greenwich, Connecticut, thinks prices of many assets and commodities will fall strongly in what he calls an “incipient deflation”.

“Ignore gold, ignore oil: they are lagging indicators of the excessively loose central bank policies we had in the past,” Lee said.

“The leading edge that is really telling us what is going on is the government bond market and property prices.”

Yields on 10-year U.S. treasuries have fallen as low at 3.69 percent, down almost a half a percent since late December.

The credit crunch is breeding new areas of concern, such as credit cards and commercial loans. Another round of losses in a new area would further dampen credit.

Citibank has more than doubled its loan loss reserve ratio on U.S. consumer debt since the end of the second quarter, with the sharpest move in the past three months.

Then there is the risk that cuts in U.S. interest rates will unravel what is perhaps the world’s biggest leveraged bet, the use of carry trades, according to Lee of pi Economics.

Estimated at as much as $1 trillion, carry trades involve borrowing cheaply in yen or other currencies such as Swiss franc that have low interest rates in order to invest in higher yielding currencies, or indeed in anything else the borrower hopes will go up.

Both the yen and the Swiss franc have rallied sharply against the dollar in recent days driven by expectations of much lower rates in the U.S.

If funding currencies like the yen and franc continue to rise, borrowers could sustain big losses. For example, many Hungarians have taken out mortgages in Swiss francs and many Korean corporations have funded in yen. Strong moves upward in the currency they borrowed may leave them unable to carry the debt.

“As the carry trade unwinds, liquidations and asset sales will push prices (down) further,” Lee said.

It seems clear that, as with the credit-fuelled boom that preceded it, the bust has taken on a life of its own.

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  1. Yves Smith


    Fair question. The scenario I have been most concerned about is one articulated by the Bank of England in its April 2007 Financial Stability report. They noted that 16 “large complex financial institutions” had become critical to credit intermediation. Can’t recall all the names readily, but the list included Barclays, Citi, Merrill, Credit Paribas (very big in credit derivatives), Credit Suisse, UBS, Morgan Stanley, JP Morgan, Goldman.

    If one or more were to become so seriously impaired that they severely cut down on their market making activities, the others would likely be suffering some hits too and would also contract their balance sheets. The world has become so dependent on securitization that it would in turn lead to less lending on a lot of fronts.

    Another bad scenario is if dollar interest rates are cut far enough that the yen rallies substantially and the carry trade shifts (or attempts to shift) from yen to dollar. That was starting to happen in the dollar rally briefly last year. I am not smart enough to think through how it plays out, but the Japanese have the biggest forex reserves in the world. They can (in theory) lend all day and they do, which has kept global liquidity going. If that process falls apart, or contracts substantially, expect very nasty consequences.

  2. Anonymous

    There’s no essential difference in the mechanics or outcome of “printing presses”, and excessive credit creation. Every cycle of easy money ends with some sort of banking credit deflation to some degree. Commercial banking credit “printing presses” create money just as easily as central banks.

  3. Anonymous

    I think it could be argued that a combination of inflation and deflation could occur simultaneously, with the deflationary presures in sectors heavily reliant on credit (and largely discretionary) while sectors traditionally funded out of present income
    (and largely subject to only modest restriction) will
    be subject to inflation. The weakened consumer, whose equity withdrawal has averaged 500B per annum over the past 4 years, now meets the newly found financial discipline of his old lender. At the
    same time, competition for scarce commodity inputs, from foods to fuels, all of which interlink at some level, are being driven up by higher growth rates in poplations much larger than our own. The BRICs are nearly 3B people.
    The Fed can surely create massive credit capacity,
    but that capacity becomes inflationary only when it is used. The sound consumers never relied on it, and the weak cannot now access it or afford it. Only the corporate sector will potentially benefit, if it is optimistic about prospects for growth.

  4. Anonymous

    Why was the Japanese experience so bad? We seam to be making the real/nominal mistake in reverse when looking at Japan (no doubt the confusion is made worse by Japanese cultural differences).

    1)Deflation in Japan during the period was understated. While the US & many Europeans used trick suck as chain weighting and hedonics to understate inflation the Japanese used an antiquated basket to overstate inflation/understate deflation. Allowing for this Real GDP growth was not bad over the period and combined with demographic trends Real GDP per head was actually pretty good. Evidence for this can be found in the consumption of luxury good which remained strong & even grew over time, hardly the shopping behaviour of the terminally depressed.
    2)A strong preference for social cohesion led the Japanese away from mass redundancies towards a social safety net of paying people for non-jobs.
    3)People moving into cities, unlike say Brits (an urban people who aspire to be country squires), Japanese dream of living in the heart of the action, the deflationary period allowed many people to move into areas they could only previously aspire to as their (considerable) savings went further.
    4)Japanese companies were highly competitive in many sectors, in mobile technology & internet connection speeds they have powered ahead.

    Lets hope the bursting of our bubble is dealt with so smoothly!

  5. JoeFourPack

    Deflation in finance sectors, auto sectors, and housing. Higher prices in food and energy. Anon at 8:25 has it right.

    Who knows what will happen if the sheeple pull their money out of banks and stock markets. There is a real crisis in confidence out there. Everything seems rigged in favor of the big boys. If you have to play cards with a bunch of cheaters, it seems logical to bet as little as possible.

  6. Viscount Haldane

    The deflationary pressures are all short term, and like other posters have mentioned, concentrated in a handful of sectors. In contrast, the longer term factors are almost all strongly inflationary.

  7. E. Cartman

    Yves, what is with this ideological aversion to deflation?

    Isn’t deflation the market’s cure for a historically low savings rate?

    Yes, in the near term, it leads to plunging consumption, which, in turn, forces a plunge in prices, until a new, cheaper equilibrium is reached. By coining unnecessary paper, as the Fed has done and continues to do, the Fed effectively freezes prices at stratospheric levels, to the benefit of the institutions who screwed up, and at the expense of “ordinary Joes” whose savings are in bonds, CDs, etc. It subsidizes speculators over savers. Again.

    As for the “short term” deflationary pressures, I still remember GaveKal’s September pieces, which declared inflation well on its way down.

    The doves who are now saying that inflation “must be” plunging are the same people who blew the call in September. Almost two quarters later, they are even more wrong, but no less brash in making unfounded, misinformed economic prognoses.

  8. don

    Two words pop out when reading your introduction: confidence and engineer.

    The emphasis on confidence is like chasing one’s tail . . . one just runs in circles. Why? Because an emphasis on a crisis of confidence doesn’t explain what lies at the root of the crisis . . . of confidence. Its dealing with effect rather than cause, giving attention to consequences rather than getting to the core of the crisis. The important matter is . . . why the lack of confidence in the first place, not that there is a lack of confidence.

    And this takes us to engineer. Restoring confidence appears not so much a matter of correcting the cause for the crisis in confidence as it is a matter of restoring the belief that the cause has been corrected, or is in the process of being corrected, and thus also the belief in the capability of the Fed to do so. The implications being that if enough believe then it will happen.

    Thus the drift more and more to psychology, to a engineering of public relations, a marketing campaign aimed at restoring confidence which is expected to lead to correcting the cause of the crisis. Again, chasing one’s tail, for it seems to me that it isn’t a matter of changing minds or attitudes or beliefs that needs addressing but rather getting to the root causes in the first place, one which I consider to be more systemic than generally acknowledged.

    I am not suggesting that the socio-psychological sphere be ignored. Instead, I’m suggesting that the emphasis given to it (and the magical effects expected from it: inflationists), is symptomatic of the deeper problem. Attempts at confidence building (whether by Bernanke, Paulsen, Bush or Congress) have turned to crisis management . . . as a substitute for getting to the root of the problem, one for which they are not capable of doing for it runs deeper than individuals and even that of institutions.

  9. EEngineer

    Put me in the deflationary camp. I’m of the opinion that the period of rampant credit creation outside of the normal banking system was our inflationary stage. Now comes the unwinding. I believe that the US Fed will try to walk the tightrope of crediting credit or money at just the rate that the previous round of credit evaporates in an effort to “peg” asset prices, particularly real estate. This will cause inflation in almost everything else though. Unfortunately the global nature of today’s market will prevent US wages from keeping up. As a result the bust of the US housing bubble will probably unfold unimpeded. Bernanke’s creation of the TAF was quite clever but I think that events will ultimately overwhelm him.
    Fasten your seat belts, it’s gonna be a bumpy ride.

  10. E. Cartman

    Don: Preach it brother.

    Confidence collapses *for a reason.* It doesn’t just spontaneously crumble. It’s sadly hilarious that Mishkin takes such a dumb perspective.

    Those of us willing to question the “wisdom” of the financial elites have profited handsomely from this latest mess, by buying gold, or shorting subprime, or similar such maneuvers. The investors who have lost their shirts are the morons who keep telling themselves that the financial elites have “contained” the “crisis in confidence.”

    “Crisis of confidence” is itself a nice little orwellian twist. It has such temporary connotations, as if a little tinkering by the high priests of the printing press will see it through in no time.

    The huge quantities of bad debt must be flushed from the system. Despite anti-market engineering on the part of the Fed, Treasury, and FHLBs, it will still happen soon. The only way the government could really keep the curdled debt on the books for the pernicious long term would be by bailing out MBIA and Ambac, which would be a disaster for the dollar.

    I ask again: what is so bad about deflation? In a vacuum, obviously, deflation is undesireable. But we aren’t in a vacuum, and there is a widely held sense among consumers that the national savings cushion is far too low. Deflation is the antidote to a negative real savings rate.

    Obviously, credit hyperdeflation is bad, but some credit deflation is necessary. It will also, if it is allowed to happen, overwhelm rising price inflation.

    However, with the Fed trending towards 75 to 100 basis points’ worth of cuts on Jan 30, there’s little prospect of real credit deflation taking place until real return on Treasuries is in the -5 percent range. Stagflation is a lot closer than people think, if it isn’t here already.

  11. Anonymous

    Isn’t the unknown known here what the central bank will do with chronic falling asset prices? Mr. Bernanke’s professional area of study is the deflation of the Great Depression and how not to repeat it. Will he now sit back with little action and watch deflation unfold? By definition collapsing credit is deflationary, but we are only in the beginning stages of a deflationary credit contraction. I wait with fascination and dread for the Central Bank and congress to act upon falling asset prices once they become readily apparent to the majority of voters. I have read Mish (whom I greatly respect) argue that the central bank will be ineffective against deflation. He makes a very persuasive argument, but again, this is an unknown known. The bank is not constrained by a commodity standard (gold). We may witness quite amazing ideas coming from the government in order to save jobs and home prices. Remember, people in 1933 turned in all their gold to the government and allowed them to outlaw private gold holdings. They did not do this because they were stupid. They were desperate. How desperate will we get and how stupid will we seem to future citizens?


  12. doc holiday

    I still think we see fragmentation and that we will have several dynamics work within the whole, i.e, deflation will impact people that were over-leveraged and inflation will slow spending down for those that were risk adverse.

    My main interest is how almost 8 years of excessive, unregulated, over-stimulated assets bubble building can be sustained in any way, shape or form, which is why a fiscal stimulus plan is tantamount to insanity — like holding a can of gas over the BBQ and trying to get the grill hot enough for burgers! If our lenders and governments would have faced up to the reality of abusing the housing market to offset the cost of the war in Iraq, we would have seen Fed rates closer to 8% a long time ago, to slow down excess speculation and to curb the bubble…..but noooo (as Belushi would scream) we had people in control that wanted more growth at any cost, but now as that cost is being examined, how do they want to solve it all…more gas on the BBQ, more stupidity and a lack of control in an endless exercise of retardation!

    Im thinking our economy will be in a hell of a lot of trouble, if we dont get a Paul Volker attitude very soon: olcker’s Fed is widely credited with ending the United States’ stagflation crisis of the 1970s by limiting the growth of the money supply, abandoning the previous policy of targeting interest rates. Inflation, which peaked at 13.5% in 1981, was successfully lowered to 3.2% by 1983.

    Also, I have to paste this somewhere today, so thanks in advance: Ambac said on Friday it had scrapped plans to issue $1 billion of new equity, in a move that may result in the bond insurer’s top debt ratings getting cut.

    The planned equity issuance was meant to shore up Ambac’s balance sheet as securities linked to mortgages and other consumer debt suffer from unexpectedly high losses.

    Markets now feared Ambac’s warning note was a signal other insurers could also be hurt on their massive bond portfolios.

  13. Anonymous

    Is money created by credit expansion different from money created by printing presses? If bank A makes a loan to business B for equipment X then when business buys equipmentg X from from business C that “money” as escaped the debtor/creditor orbit. Now when business B fails to repay the loan, bank A has to right off an “asset”. But the money it created for business B is still out there for business C, D, E ….

  14. Yves Smith

    I agree with the thread that we could see inflation in consumer goods and asset deflation. We are already going down that path.

    I also agree (and have said repeatedly) that there will be sustained credit contraction. The level of credit relative to GDP has risen to ridiculous and unsustainable levels.

    What bothers me most about the debate in the media and Washington is the lack of interest in regulatory reforms. Thanks to Reagan and Milton Friedman, we have an intellectually incoherent faith in free markets. Now if by free markets you mean “a system by which pricing rather than central planning is the main/preferred mechanism for resource allocation” no one would disagree with that as a good concept. But that high level abstraction has been taken way way beyond its optimal form to be equated to “regulation in any form is bad.” And that is just nuts.

    My buddy Amar Bhide (Harvard then Columbia B School prof) wrote a very important and largely ignored paper in which he pointed out that the market that most people liked to cite as an example of a successful, well functioning market, the stock market, was in fact heavily regulated. Never before was something as ambiguous as a stock traded on an anonymous, arm’s length basis for sustained periods of time (previous efforts all wound up with large-scale fraud and collapse). But we may need another collapse (I hope not) to shake the prevailing ideology.

    E. Cartman,

    Good question (yours of 11:39 AM). The classic fear re deflation is that of a so-called liquidity trap. Consumers have no incentive to spend because goods will be cheaper, and no incentive to save because interest rates are too low. People hold and hoard cash.

    Now if you think about it, that may not make as much sense as it seems to. People need to eat, buy gas and laundry detergent whether prices are falling or not. Cell phones, computers, and consumer electronics are subject to marked deflation, yet people buy them avidly (of course, they have been clever in also creating forced obsolescence and short product lives). The US had mild deflation for much of the 19th century.

    Similarly, the Japanese have had high savings rates despite near zero yields (of course, their government has allowed banks to provide retail products to enable them to chase higher yields overseas). But that is party due to poor social safety nets in Japan, greater job insecurity, and frankly, teeny houses (how much can you spend on stuff if you have no place to put it?)

    I have long thought that the telling of the Depression story placed too much emphasis on monetary policy and too little on institutional failure. The fact is, as Paul Krugman pointed out, the Fed DID increase the monetary base, which is the one thing they control directly. Money supply nevertheless fell because people pulled cash out of banks. And that was completely rational because banks were failing (my maternal grandfather got 3 cents on the dollar he had deposited).

    In the modern world, unless we have massive bank collapses, people would not keep their money in mattresses. And in a deflationary environment, you’d probably see a pretty flat yield curve, so there wouldn’t be much risk in maturity transformation.


    Agreed that the emphasis among the powers that be on restoring/maintaining confidence is likely overdone. However, what we just saw at year end was a crisis in confidence in the form of banks unwilling to lend to each other. That was mainly due to lack of transparency. No one knew how badly damaged anyone else was, and they were hoarding liquidity for themselves because they were concerned that a failure or further impairment would lead to a worsening of the seize up.

    Now the TAP and other measures actually worked, at least for the moment. So the monetary authorities now have an example of one of their finesses addressing a problem of information AND confidence.

    Further, I believe these “con” measures are directed at the stock market, even though that is NOT the Fed’s job. Greenspan took way way too much interest in the general level of stock prices, and saw them as validation of his policies. My impression is that his world view has infected the Fed. And if you believe Martin Wolf, stock prices globally even at current levels are well above long-term historical averages. It has been remarkable how the stock market has kept shrugging off, until recently, the bad news from the credit markets.

  15. Anonymous

    “the US Fed will try to walk the tightrope of crediting credit or money at just the rate that the previous round of credit evaporates in an effort to “peg” asset prices, particularly real estate. This will cause inflation in almost everything else though. Unfortunately the global nature of today’s market will prevent US wages from keeping up.”

    The problem of low US wages is a known unknown, because we haven’t seen a cycle in which the power of labor has been broken.

    (Note to elites: be careful what you wish for.)

    If we have inflation, in a cycle of falling or stagnant wages and rising unemployment, the economy contracts further. It will contract and contract until the demand for those commodities shrinks.

    So, if inflation in commodities takes hold, the eventual size of the economy at which the contraction stops is smaller than it would be if there were no inflation.

  16. David Pearson

    In the end deflation and inflation are political choices.

    Some governments will elect to fight credit contractions with ballooning deficit spending. The resulting spike in real interest rates, caused by “crowding out”, only makes the problem worse. The ball lands in the Central Bank’s court: finance the deficits to bring down real interest rates, or accept record unemployment. More often than not, Central Banks opt for the former. There are literally dozens of examples of this occurring, most notably in Latin America.

    There is but one example in recent history of the opposite being true: in Japan, the Central Bank never faced the choice of deficit financing. Unlike EVERY other country, Japanese savers were glad to finance their government’s deficit. No capital flight, no flight from the banking system, and a sky-high savings rate were all unique features of Japanese deflation.

    So basically, it comes down to two things:

    Will the U.S. government use the Central Bank to finance spending?

    Will U.S. savers keep their money here, or send it abroad?

  17. doc holiday


    I appreciate your added comments today and that type of dynamic interaction (from you), once in awhile is helpful in sparking new ideas or all of us poor blogging surfers.

    I wanted to also add that any debate of economics always seems to have built in lag periods where information is digested and then used as a basis for whats next.

    Thus we often hear that Fed rate cuts are not felt for six months or so, which in my mind makes the current panic to cut, and cut more deeply somewhat suspect and an over-reaction as to how much stimulus is needed to save us all from ruin — so as to allow more walmarts to be built and more McMansions to spread like wildfire as in an out-of-control pandemic.

    The point being, where is the recognition of reality that there are cyclical periods of expansion and times where sustained hyper-growth are not realistic? We have just seen a massive amount of never before seen global collusion where derivatives have been packaged and linked to every possible asset in the world that could be consolidated into daytrade/monetized vehicles that are based entirely on illusionary financial engineering mechanics!

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