Deflation Worries Looking More Credible

Ambrose Evans-Pritchard has not given up on his deflationary views, which until recently were quite an outlier. But some recent data releases give support to his downbeat take. From the Telegraph:

CPI inflation has dropped to –2.2pc in Japan (a modern record), -2.1pc in the US, -1.8pc in China, -1.4pc in Spain, -0.7pc in France, and -0.6pc in Germany.

This was not anticipated by the authorities anywhere, so we should be wary of their assurances now that we face nothing more than a brief dip in prices before rising energy costs bring inflation back into familiar and safe territory. No doubt prices will rebound as the “base effect” of oil prices kicks in. But by how much; for how long?…

White House aides are already mulling another blast of spending. It won’t fly. We have hit the political limits of such extravagance almost everywhere. The fiscal crutches of recovery are going to be knocked away, with outright tightening in a slew of states nearing the danger point of debt-compound spirals. This will occur in a world where excess capacity is already at post-War highs. It reeks of deflation.

Irving Fisher explained why the self-correcting mechanism of economies breaks down in his Debt Deflation Theory of Great Depressions in 1933: “Over indebtedness to start with, and deflation following soon after”. Most of the West has exactly that, but worse – debt is much higher.

Admittedly, this view is far from mainstream, but Thought Offerings pointed to some like-minded views and offered some data of its own:

In recent months I’ve noticed an increasing amount of commentary on the intensifying deflationary forces in the US and global economy, for example Albert Edwards:

: With import prices down some 19% yoy and even a record 7.3% yoy if one excludes petroleum, no wonder the price of domestic purchases has already fallen into deflation. If anything, domestic purchases inflation leads trends in both GDP and core CPI, so this is significant news.

….Chris Whalen of Institutional Risk Analytics gets colorful in his latest newsletter, Q2 2009 Bank Stress Test Results: The Zombie Dance Party Rocks On:

Despite all of the talk and expenditure in Washington, the US banking industry is still sinking steadily and neither the Obama Administration nor the Federal Reserve seem to have any more bullets to fire at the deflation monster.

…..To visualize Consumer Price Inflation, I’ve only seen graphs of period-based changes in the price level (month-on-month or year-on-year), such as this chart from the July 2009 BLS CPI report:

….Since I couldn’t find any graphs of price levels (as opposed to change in price level), even though they must be out there, I made my own. Here is the first showing consumer price index trends in the US today compared to the Great Depression:

The place where all the lines meet on the chart (at 31 months) is normalized to 100% with all price levels relative to that peak. This point corresponds to July 2008 for the modern data and November 1929 for the Great Depression data. I have chosen to show several years preceding this point to give context to how quickly each measure had risen before peaking. Some observations:

CPI has been measured with different methodologies at different times, so this is not an apples-to-apples comparison.

After peaking in July 2008, headline CPI plunged at a faster rate than the onset of the Great Depression. No wonder (among other reasons) treasuries rallied so dramatically at the end of 2008 and then reversed as headline CPI started heading higher again!

Core CPI (excluding food and energy prices) has kept rising, but the pace of increase is slowing in 2009, even with energy prices relatively stabilized, despite coinciding with the largest monetary and fiscal stimulus in history! Is the battle with the “deflation monster” being slowly lost?

Looking at the BLS year-on-year CPI chart further above, the trough in the rate of change of core CPI of around 1% in early 2004 was almost four years after the dot-com stock market bubble popped, and over two years after the recession lasting officially from March 2001 to November 2001 ended! So (at the risk of being wrong by using only one data point) impacts to core CPI seem to lag recessions and changes in asset prices by years. It seems likely that this trend will replay today.

Headline CPI has turned (mildly) negative again in July — will a full downward trend resume? Might we face price deflation as ferocious as in the Great Depression? Personally I think it unlikely, but can’t rule it out entirely.

I added energy prices to the graph because they have been so volatile (whether due to global demand exceeding supplies, rampant financial speculation in energy as an asset class, or some combination of both). One way of looking at the effect on headline CPI is that the violent energy price spike simply forced headline CPI higher between mid 2007 and mid 2008 and that this is the primary cause of current deflation. While partially valid, I don’t think that’s the whole story.

He has a series of additional charts with commentary on each, all very illuminating. Continue reading here.

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  1. Ed


    Can you make a copy of your Price Index chart available in a higher resolution / or in a “zoomable” format. I’m not able to resolve the axes or the info on the chart.


  2. jgw

    The graph showing consumer price levels would be more convincing if it was readable. Any chance of publishing a key?

  3. Brick

    A deflationary environment and CPI inflation are not necessarily the same. For me a deflationary environment is where employees have no wage negotiation leverage and companies try to grab market share by reducing margins and costs. There is no doubt in my mind that we are in a deflationary environment and will continue to be in one for some time.
    The problem is that price inflation is affected by multiple factors of which a deflationary environment is just one. Speculation plays its part along with relative currency valuation. One of the interesting things you quoted was the 7.3 percent drop in import prices which if you take the drop in the value of the dollar into account, suggests to me that deflation is being imported from China. I am not in the imminent dollar collapse mindset but do expect it to continue to decline somewhat. More at risk I expect is the Yen, the Euro and Sterling.
    Many people are thinking about whether the great depression or Japan’s lost decade hold the future for us, yet history tells us that most deflationary environments end with a currency crisis. For me the real danger is the simultaneous combination of asset deflation and monetary or price inflation, in effect a deflationary environment with rising prices.

  4. But What do I Know?

    **Despite all of the talk and expenditure in Washington, the US banking industry is still sinking steadily and neither the Obama Administration nor the Federal Reserve seem to have any more bullets to fire at the deflation monster.**

    They do in fact have another bullet–more of a bomb, really. To use it requires only the Will. This final option is to send every taxpayer in the country (or every adult, or every person) a check (or stored-value debit card) for $10,000 (or $5K, or $20K).

    I am not advocating for this, or suggesting it is a good idea. It would be a desperate measure, but it may be in a few years that the party in power is desperate–and there’s nothing Congress likes better than handing out money. And it would end deflation. It is important to keep this in mind when someone opines that deflation is inevitable, or that the government is “out of bullets.”

    This version of the Deplorable Word (cf. C. S. Lewis) could also come in the form of a temporary moratorium on federal taxes–a step that would favor the wealthy. But in any case, it would allow the US to competitively devalue its currency in a way that it cannot now (with our trading partners outside of the Eurozone effectively pegging to the dollar). The mere threat of it could force China and the Gulf States to allow their currencies to strengthen.

    Of course, any measure of this kind would be ultimately insane–how would we get any of our needs provided for if money loses its motivating force–but that doesn’t mean it wouldn’t be adopted (especially on a creeping basis, or as a “one-time” get-the-economy-going-again measure, and if presented as a “war-time” attack on “economic distress.”) After all, the federal government will only take in roughly half of what it will spend this year, and it doesn’t look all that different next year absent tax increases. What’s another couple of trillion dollars of debt?

  5. Mike

    It would ne nice to have a link to a larger version of the chart for “consumer price index trends in the US today compared to the Great Depression:”

  6. joebhed

    In mentioning Irving Fisher’s Debt-deflation theories, it may be of value to probe further down that path, as has been done before.
    His “syndrome”, if you will, for the debt-deflation spiral to the bottom has a number of markers that are as relevant today as they were when penned, even with the social-economic and financial reforms of the mid-30’s.

    However, most notable for me was Fisher’s advice on how to AVOID this inflate-deflate cyclicality – his earlier and subsequent calls for 100 Percent Money, nominally referred to these days as full-reserve banking.

    Along with Henry Simons, Milton Friedman and many others, Fisher saw that it was the debt-money system of fractional-reserve banking that was the CAUSE of the problem, and all advocated abolishing the federal reserve and debt-money, just as many Austrians and Libertarians do today.

    Given the breadth and depth of the abyss awaiting the fall of the debt-money system, it is worth a question as to whose job it is to develop the needed exit strategy from fractional reserve “parasitism”.

    This will be widely discussed a the upcoming American Monetary Institute monetary reform conference in Chicago.

    The Money System Common.

  7. Yves Smith Post author

    Sorry re the size of the charts. I did make them larger, but the tradeoff is they are now a bit blurry.

  8. Siggy

    Joebhed has a very inciteful comment.

    The engine of the generation of excess credit money is the fractional monetary reserve system.

    The next difficulty lies in the realm of fiat currencies. Going back to the Gold Wars and DeGaulle, who had it right, the collapse of Bretton Woods was inevitable given our propensity to inflate the money supply. The recent demise of Glass-Steagell and the Comodity Futures Trading Modernization Act were the accelerants thrown on the smoldering problem.

    We desparately need a dialogue that addresses the core problem; What shall be Money?

  9. John Kissinger

    The following link is to a chart from Mish that substitutes Case-Shiller housing data for USG owner equivalent rents in BLS CPI, and compares this result with BLS CPI and the Fed Funds Rate. I have long thought that the BLS underestimated inflation during the boom years and overestimated inflation in the bust years… according to this chart, real CPI is over 6% and rising.

    Incidentally, the Fed Funds Rate should be higher than the real inflation rate to control inflation, one can see just how far off the Feds were over the past decade or so.

  10. Bruce Wilder

    YoY gives a misimpression as to the timing of inflation/deflation. It would be better, I would think, to use the 3-month moving average as a tracking number, to discover when deflation takes hold. Too often the y-o-y number is going to track past inflation spikes or dips instead of current developments.

  11. Dave Raithel

    RE Reds8ter: Certificates of denomination at some weight of stones payable on demand come into existence; guards are hired to secure the gravel pits; nobody leaves such a site without a body-cavity search…

    Siggy’s and Joebhed’s and Reds8ter’s comments, and the links they submitted at which I’ve been looking the last couple of hours, confirmed to me what is perhaps obvious to many others more advanced than my perpetually auto-didactic self: Those who object to the Federal Reserve have reasons that are superficially similar – at most, skin deep. They are not aligned to the bone.

    A sense of desperation, of flailing about, envelopes me ….

  12. ScottB

    John Kissinger, using Case Shiller instead of owner-equivalent rents greatly overstates inflation, since most homeowners fact little or no increase in housing costs on a monthly basis–many have already paid off their mortgage, many of the rest have fixed monthly payments. Only new homebuyers and those whose ARM is up would have a substantial increase in their cost of living.

  13. Sivaram Velauthapillai

    Joebhed: “…his earlier and subsequent calls for 100 Percent Money, nominally referred to these days as full-reserve banking.”

    Name a country or scenario that has had 100% reserve banking. If you can miraculously find one—there isn’t one after 1800 I believe—name a situation where that country prospered.

    I’m not an economist but it’s quite probable that, in a free market, country/banks/etc that offer fractional banking will attract more customers than the full-reserve banks. A country that has full reserve banking has no monetary policy (this is favoured by some extreme libertarians who distrust all government, including the military) while a country that has one does have a monetary policy. Although governments can make mistakes, I know which side I will bet on—the one with monetary policy.

    There is a reason USA, which never used full reserve banking AFAIK, started dismantling the gold standard (which is closer to full reserves than pure fractional fiat banking) during the 1930’s. It was virtually impossible for USA to compete against the world!

    There are reasons why full-reserve banking essentially died after 1800 (or even earlier); and why the gold standard died in the 1930’s (or in the 70’s in USA, depending on how you define it). It’s easy to blame governments for it but I actually think it was free market forces that killed those systems. If you think of currencies as being a market itself, there were various choices in the 1930’s (some backed by gold, some with no backing, some issued by dubious countries, some stronger countries, and so on.) The market itself was the one that decided that USA had to go off the gold standard. Yes, the government passed the laws but they were reacting to the market forces.

  14. Thought Offerings

    Sorry the original inline charts are so small… Yves’ copy is not clickable so you really need to follow the link through to the post and click on the copies there to enlarge them.

    @ But What do I Know? – I think Japan has tried using the gift card “solution” and while I don’t know the scale or way it was implemented, whatever they tried definitely hasn’t caused sustained inflation yet. As long as consumers are determined to save more (negative wealth effects, unemployment, spent savings, etc)… Then as I see it the gift cards would have to restricted to things that no one really needed (a little hard to choose and justify politically!) — otherwise, since money is fungible, a large portion could just be used to buy food or other necessities with the difference added to savings or debt repayment, potentially even accelerating deflation. I think you’d have to break the frugality mindset first and create a new and lasting “illusion” of wealth…

    1. Vinny G.

      @ RedSt8r said: “I propose we consider the stone money of ancient Yap. How would Goldman Sach’s pay bonuses if money were stones? Gravel pits?”

      May I propose we pay their bonuses by means of an ancient process known as “stoning”?…

      Anybody here volunteers to throw the first stone?…

      Vinny G.

  15. Siggy

    Ya’ll kicking on my dog!

    Get serious! How do you propose to have a fiat currency that can serve as a store of value. That is the implicit problem. The function of a gold based currency is that the paper was/is a claim against a quantity of gold. The store of value is the gold.

    Fractional reserve banking leads to the issuance of a quantity of paper whose purchasing power is greater than that of monetary base quantity of gold. We call this loss in purchasing power inflation. Inflation is facilitated by the creation of Credit Money, spends like money excepty you have to repay it. Also, inflation is quite lovely for the first recipients of the inflated paper. Each party thereafter receives something that has less and less purchasing power.

    Governments favor a fiat currency in that it is the perfect vehicle for the debasement of the currency. The most common resort to paper money was to finance a war. In the current environment we are financing two wars and a very substantial set of entitlement programs. Governments that cannot tax directly, generally resort to the debasement of the currency. We’ve been doing it for a very long time.

    The issue at hand is the preservation of purchasing power in the face of profligate borrowing that has been facilitated by easy credit. If we are to preserve the Republic, we had better fix the currency and educate the public that borrowing more than one earns leads only to slavery.

    It appears to me that the public is beginning to realize that you cannot borrow infinitely. That purchasing power does matter and that savings are necessary to fund future consumption. Deleveraging will trigger deflation and that of itself is not too serious a problem except that it is even harder to control than is inflation. Nonetheless, we must delever and redistribute our resources to more productive endeavors. That’s very bad news for a lot of people aged 45 plus. It means a whole new career at what will probably be a lower wage. Interestingly, relative to the rest of the world, our living standards are in decline while most of the rest of the world is seeing what is for them improving living standards. It’s an equilibration of labor costs.

    Now as to fractional reserves, 100% may be too draconian, on the other hand it is clear that we are incapable of controlling credit at a required reserve rate of 6% or so.

    Another thought, is your checking account a loan or a bailment. If its a bailment, the banker is contractually commited to repaying in full, and he can charge a fee. If its a loan, you’d better be collecting some interest, but you have increased risk that you may not be repaid infull.

    Oh, by the way have you looked at your currency lately? The issuer is the Federal Reserve, read the damm bill; “Federal Reserve Note” . . . “Legal Tender for All Debts Public and Private”. The automatic deposits you receive from employers and the like are a virtual representation of the currency in your pocket as are the credit/debit cards. The treasury doesn’t issue currency anymore, it sells debt.

    China and others are making noise that the world needs a better reserve currency. Why? Loss of purchasing power! Fractional Reserve Banking has facilitated profligate spending that has been financed by easy access to credit money, not hard currency. Just as DeGaulle held, we have exported our inflation while the mercantilist exporters thought they were livin high on the hog of our profligacy.

    Just what is China’s greatest fear, that we will repudiate our debt.

    1. Jeff65

      You mistake that the purpose of money is to store value. The purpose of money is to facilitate trade. The fact that it is also a store of value has had nothing but negative consequences. Because money is a store of value, it allows you to ignore your trading relationships, community standing, reputation and many other things to a much greater degree than you could if it were not.

      1. Siggy

        You miss read my point. If money no longer functions as a store of value, you must spend it! In that motivation lies the cause of excess consumption funded by borrowing.

        I agree that the the primary function of money is a medium of exchange and unit of account.

  16. andrewg

    For those of you inclined towards libertarian/austrian sentiments, know that there is nothing wrong (i.e. anti-free market or anti-libertarian) with fractional reserve banking. What is wrong (from that same standpoint) is (i) socializing the risk thereof (e.g. FDIC guaranteed deposits, bank bailouts, etc), (ii) a central bank controlling/influencing the money supply through interest rate policy or otherwise, and (iii) government monopoly over currency issuance.

    Sivaram, you are correct that development of a fractional reserve system is an inevitable result of market forces. But there is no way that going off the gold standard was simply the result of market forces, as you state. For whats it’s worth, the gold standard is just like democracy: the worst form of monetary policy ever invented except for all the rest. Sooner or later it will return because sooner or later all fiat currencies go the way of the dodo.

    One last thing: Fisher in his Debt-Deflation paper, himself specifically states that a debt-deflation is ultimately self-correcting, albeit after “needless and cruel bankruptcy, unemployment, and starvation.” I’m tired of reading economists and others state that a debt-deflation is a never ending spiral from which an economy cannot recover without intervention.

  17. moslof

    I am glad you linked to Prechter for his insights into credit deflation. The idea of printing money to inflate at this point in the game is ludicrous and he explains why better than anybody. His prediction of real estate declining 90% is more credible with every passing day. Gold’s day will come when the herd is finally convinced that cash is king.

  18. But What do I Know?

    @ Thought Offerings: I would be interested in knowing more about the Japanese “gift card” experiment–how much was it, who received it, and was it perceived as potentially ongoing. It seems to me that a large enough transfer would do the trick. Also, our situation is a little different from Japan’s because so many of our trading partners peg their currencies to ours it is difficult for us to devalue. It could lead to a game of chicken–if they won’t float their currencies, we’ll just keep creating more of ours.

    The question of whether the money would be spent or saved is unanswerable without trying it, but I would appreciate if you or any other commentators could provide some data on Japan or anywhere else this has been tried.

  19. Hugh

    I think we need to take a broader view of deflation than measures like the CPI. Major deflators in the economy have been the bursting of the housing bubble and the high levels of unemployment. Both serve to contract demand. In the same way, the relative lack of availability of and/or demand for credit also contracts demand. Against these, we have the massive bank bailouts, mark to fantasy accounting rules, the suckers stock market, and speculation in the oil market which are artificially supporting price in the presence of contracting demand. There are also a few aspects of our limited social safety net like unemployment insurance and parts of the Obama stimulus that actually increase demand. When the artificial supports dry up or decrease, a lot of pent up deflation will be unmasked. The question is how long can the Obama Administration pump up markets while leaving the real economy to fend for itself.

  20. snake

    Create jobs and prices will go up.

    There is no other way around it, unless you flood the markets with credit again.

    Tough luck on that last one, because everyone is now able to recognize the cheating hand when they see it, and they’ll take their chips and get out if they see it in the game again.

  21. psychohistorian

    One of the early commenters Brick ended by saying: “For me the real danger is the simultaneous combination of asset deflation and monetary or price inflation, in effect a deflationary environment with rising prices.”

    Asset deflation with housing – check

    Monetary inflation (how many T in the past year?) – check

    Price inflation – this is one of those mixed bags where elasticity of demand and where various products are produced/consumed matter. It is doubtful that necessities like food and shelter will see much deflation as their demand is fairly inelastic. The rest of the consumable product mix will see much pressure on prices as folks with any disposable income figure out what beyond necessities they wish to buy and at what price point they will consume how much.

    I believe we (US) will see both strong deflation and inflation in the next year. The heuristics of the system are not settling down, they are getting worse. The damn thing may sputter and die here one of these days. What will we do then? Maybe we can reset the moral and ethical standards for societal interactivity if that happens…..

  22. Skippy

    @psychohistorian said…Maybe we can reset the moral and ethical standards for societal interactivity if that happens…..

    That is my one and only mental pacifier, as some one who unfortunately has seen the alternative, I need to believe it could happen.

    Skippy….but as your moniker implys understanding of such events, it is not the case most of the time.

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