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[Suresh]

Perhaps, there will be no wage-price spiral because there will be surplus available labor with Baby Boomers looking for at least part-time work during their retirement years. The absence of a wage-spiral, of course, would provide cover for the Federal Reserve, for example, to maintain its overly accommodative monetary policy.

I don't see how wage deflation wouldn't affect consumers though. I think there will be a rising consumer price inflation rate in terms of necessities, and that rising consumer price inflation rate will be particularly onerous for those with falling household incomes.
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Market Folly: Dennis Gartman Sees Both Inflation & Deflation
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Dennis Gartman ... a noted trader, a hedger, and author of The Gartman Letter[,] ... is out saying that he sees both inflation and deflation.
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He explains that due to the weak US dollar complex, commodity prices are going up, indicating inflation in assets. He specifically cites the action in grains, crude oil, and copper. In fact, in the past, Gartman has even said he could see gold being the world's reserve currency. So, while those assets are signaling inflation, he cites deflation in employment and labor prices. Additionally, he points out that housing prices are in a deflationary spiral and he says that, "homes are not going to go up for a long time." Curiously enough, Gartman thinks that the impact on the consumer will be negligible. We're not exactly sure how his rationale behind that works out though.
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In terms of economic recovery and world strength, Gartman thinks that the United States and Europe are the only two that will still truly be in the house of pain. He sees economic recovery beginning to occur in the emerging market nations such as China and Brazil, while other countries are beginning to benefit such as Australia. However, he thinks the US and Europe will be up a creek for a while longer. You can put on this pairs trade by simply going long Australia, Brazil, Canada, or any other number of world markets, while simply shorting the US markets or those of Germany, France, and Japan. Simply put, Gartman likes being long the 'new world' commodity exporters and short the 'old world' commodity importers.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

There will be pricing power for necessities and particularly those necessities suffering from shortages. Debt repayment as a brake on money velocity assumes that debt repayment is a choice. It may not be. Debt repayment is only an option after all household operating expenses are met. For example, people still must eat and go to work, directly or indirectly consuming some fossil fuel. We've posted several article excerpts of the coming oil shortage around 2012. Price spikes from such shortages will eat up more and more household income, leaving little for debt repayment.
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Fortune: One man against inflation
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This "inflationist view of the world," which [Van Hoisington, president of Hoisington Investment Management] outlines in his firm's recent quarterly review and outlook, stems from Milton Friedman's observation that "inflation is always and everywhere a monetary phenomenon." Hoisington goes on to say that "the Fed has expanded the money supply dramatically, and since inflation is too much money chasing too few goods," people think inflation is inevitable. But he thinks they're wrong.

For starters, Hoisington believes the economy will continue to be weak for years. And with unemployment at such high levels, companies won't be raising wages, and consumers won't be increasing their spending. That means demand for commodities and other goods will be muted, so there will be no upward pressure on prices. Overall, he sees the economy being no bigger in 2012 than it is today.

Even if inflation and interest rates were to rise in this recession or the beginning of a recovery, the economy would quickly stall. "With unemployment widespread, wages would seriously lag inflation," he writes. "Thus, real household income would decline and truncate any potential gain in consumer spending."

What about all the money the government is pumping into the system? That's not by itself inflationary, he says, pointing to the work of economist Irving Fisher (who died in 1947).

Fisher believed that gross domestic product is equal to money times its turnover, or velocity, which is basically, the speed with which people spend it. In the last two quarters, money supply has grown at 14% but velocity has declined by about 17%, so nominal (non inflation-adjusted) GDP fell 4.5%.

One reason velocity is down, according to Hoisington, is that people would rather repay debt than go out and buy a lot of new stuff. He points again to Fisher, who wrote in a 1933 article "The Debt-Deflation Theory of Great Depressions" that excessive debt controls all, or nearly all, other economic variables.

Hoisington sees this today. "People are more interested in trying to get out of debt than increasing it, which means the economy cannot grow," he says. "If there's no increase in demand, there can be no increase in prices."

For investors, Hoisington warns in his paper that "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."

During that two-decade period, Treasury bonds had a higher total return than common stocks, he notes. And he says investors shouldn't expect this to change: "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." To top of page
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Suresh

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[Suresh]

RealClearMarkets: Van Hoisington's Low Inflation Outlook Isn't
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[Austin, Texas based money manager Van Hoisington, president of Hoisington Money Management,] makes the point that thanks to economic weakness that he presumes will be with us for some time, companies won't be raising wages, thus no inflation. The problem there is that the labor force's quantity is hardly static. When demand for workers is low, many go to the sidelines or, as has been the case recently in Las Vegas, many will leave geographical locales where labor demand is low altogether. High unemployment can't change the level of wages in any sustained way given the basic truth that workers are mobile.

In much the same way, low levels of unemployment similarly can't change wage levels either; this despite protests from the Federal Reserve which suggest they can. The problem with the Fed's thinking is that it doesn't account for rising wages luring sidelined workers back into the workforce, nor does it account for the migration of workers from weak economic regions (think Detroit) to growth regions such as Silicon Valley. The logic here also doesn't account for the basic truth that U.S. firms regularly access the world's labor pool in producing the goods we buy, not to mention innovations such as the ATM and computer that make low supplies of labor less pressing.

Hoisington goes on to argue that high levels of unemployment mean that consumers won't be increasing their spending. At first blush he might have a point, but what can't be forgotten is that no act of saving or lack of spending can in any way detract from demand. That's the case because unless our savings are put under the proverbial mattress, they're either being lent to entrepreneurs with immediate demands or consumers eager to purchase what they presently can't.

In that sense Hoisington's argument that debt repayments will put a damper on prices doesn't stand up to the greater reality that one man's debt burden is another man's income stream. Many Americans will spend the next few years paying off debt, but those dollars must by definition go to someone else who previously delayed consumption. Dollars are dollars are dollars, and all debt repayments tell us is that the profligate will transfer their earnings to the prudent. Spending power won't change thanks to debt.

More broadly, Hoisington argues that future economic weakness will mean that demand for commodities and other goods will be muted. At first glance this too makes sense, but the greater reality is that supply and demand are but two sides of the same coin, or identical. In that sense, if there's lower demand in the future, it will surely be the result of lower supply with no price level change. Indeed, we can only demand insofar as we supply first; that, or we can borrow against the productivity of others willing to lend to us based on their optimism about our future productivity.

So while basic supply and demand when it comes to goods prices can't be inflationary or deflationary, changes in the value of the currency - in our case, the dollar - can. And when we look at the dollar, be it against foreign currencies or a more objective commodity such as gold, the dollar has been impressively weak dating back to 2001.

Not only are we inflating, but we have been for quite some time. And inflation regularly correlates with economic weakness given the basic truth that when money loses value, capital flows into hard, unproductive assets, and away from the entrepreneurial, wage or growth economy.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

Many blogosphere pundits have called for the Federal Reserve to rein in money supply and raise interest rates a la Paul Volcker in the 1970s. But, Jesse in his commentary below puts his finger on why such a monetary policy is a non-starter. Given the size of the national debt, high real interest rates would force the federal government to default on its sovereign debt and would crush the economy. Therefore, the only hope is for an expansionary monetary policy to grow the economy faster than the growth of the money supply. Major fiscal and monetary policy makers do not know for sure whether such an expansionary monetary policy will cause disinflationary growth, hyperinflationary growth, or stagflationary growth. Incredibly, that uncertainty appears to be the basis for choosing this course of monetary policy -- that it simply avoids the known evil of a deflationary depression!
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Jesse's Cafe Americain: Some Common Fallacies About Inflation and Deflation: the Weimar Nightmare in Review
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The first of these monetary fallacies is that 'the output gap will prevent inflation.' The second is that a lack of net bank lending or other 'debt destruction' will require a deflationary outcome. Let's deal with the output gap theory first.

Output gap is the economic measure of the difference between the actual output of an economy and the output it could achieve when it is most efficient, or at full capacity.

The theory is that when GDP underperforms its potential, with unemployment remaining high, there can be no inflation because demand is weak and median wages will be presumably stagnant.
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The thought is that sustained inflation is due to a 'wage-price' spiral. Higher wages amongst workers cause prices to rise, prompting workers to demand higher wages, thereby fueling inflation. If workers do not have the ability to demand higher wages there can be no inflation.

While this is in part true, it tends to confuse cause and effect.

The cause of a monetary inflation, which is a broadly based inflation across most products and services relatively independent of demand, is often based in a monetary expansion of the currency resulting in a debasement and devaluation.

A monetary expansion is relatively difficult to achieve under an external standard since it must be overt and often deliberative. A gradual inflation is an almost natural outcome under a fiat currency regime because policy-makers can almost never resist the temptation of cheap growth and the personal enrichment that comes with it.

There can be short term non-monetary inflation-deflation cycles that tend to be more product specific in a market that is not under government price controls. But this is not the same as a broad monetary inflation or deflation.

The key difference is the value of the dollar which has little or nothing to do with a business cycle or product demand/supply induced inflation/deflation.

In the modern era the Federal Reserve can increase the money supply independent of demand by the monetization of debt, with the only restrictions on their ability to increase supply being the value of the dollar and the acceptability of US sovereign debt. This requires the acquiescence of the Treasury and the cooperation of at least one major money center bank.

People tend to invent 'rules' about how the money supply is able to increase, and confuse financial wagers and credit with money. This is in part because the average mind rebels at the reality behind modern currency and the ease at which it can be created. Further, people often invent facts to support theories that they embrace in an a priori manner.

In a pure fiat currency regime, the swings between inflation and deflation are almost always the result of policy decisions, with the occasional exogenous shock. A government decides to inflate or strengthen their money supply relative to productivity as a policy decision regarding spending, central bank credit expansions, banking requirements and regulations, among other things.

As a prime example of a rapid inflation despite a severe economic slump, what one might call uber-stagflation, is the Weimar experience.
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If one can obtain a copy, as it is out of print, one of the best descriptions of the German inflation experience is When Money Dies: the Nightmare of the Weimar Collapse by Adam Fergusson. There is a copy of the book available online for free here.

From my own readings in this area, the people who tended to survive the Weimar stagflation the best were those who:
1. Owned independent supplies of essentials including food and shelter and were reasonably self-sufficient.
2. Had savings in foreign currencies that were backed by gold such as the US dollar and the Swiss Franc
3. Possessed precious metals
4. Belonged to a trade union and/or had essential skills or government position which guaranteed a wage
5. Were invested in foreign equity markets, and even in the domestic German stock market for a time

People will argue now that the Fed understands that inflation is caused by perceptions, and that by managing those perceptions inflation can be avoided because even those prices are rising and the currency is being devalued, if they ignore it the inflation cannot reach harmful levels.
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Granted, perception is important, and managing perception may delay outcomes for a period of time. But unless the underlying cause of the problem is remedied during what is at best is an extended interlude, the resulting break in perception will ignite a firestorm of cognitive dissonance, loss of confidence, and social unrest.

In summary, in a purely fiat currency regime a sustained monetary inflation or deflation is an outcome of policy decisions regarding fiscal policy, monetary policy, and economic balance and output.

As long as the government is able to generate debt, deflation is a highly unlikely outcome. And when the government reaches the practical limits of debt creation, the underpinnings of the currency give way and the economy tends to collapse in a stagflationary slump.

There are no predetermined outcomes in a fiat monetary regime. Deflation, stagflation and hyperinflation are not 'normal' but are certainly possible if the central authority is permitted to abuse the real economy and the money supply for protracted periods of time.

What about Japan? Japan is the perfect example of a policy decision made by a fiat currency regime in what was decidedly NOT a free market, but under the de facto control of a highly entrenched bureaucracy, a single political party, and large corporate giants in pursuit of an industrial policy that favored exports and domestic deflation.

The difference between the Japan of the 1980s and the US of today could not be more stark. Choosing a deflationary policy and high interest rates as a debtor nation is economic and political suicide. It would be interesting to see what happens if the US elites try to take that path.

We will know if there is a true monetary deflation in the US because the value of the dollar will start increasing dramatically with regard to other hard assets, other currencies, goods and services, and precious metals and commodities. Prices will decline especially for imports as the dollar gains in purchasing power.

Remember that a true monetary inflation and deflation would only show up over time. Even in the Great Depression in the US, as demand slumped and prices fell, the stage was set for a significant devaluation of the US dollar and a rise in consumer prices well in advance of the eventual recovery of the economy that caused the Fed to tighten prematurely. As I recall the actual contraction in money supply lasted two years. This again highlights was an amazing piece of bad policy that Japan represents in its 'lost decade.'
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Our own view is that a serious stagflation with further devaluation of the US dollar as it is replaced as the world's reserve currency is very likely, after a period of slackening demand and high unemployment.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

We've been wondering for some time how money velocity will increase from presently low levels. We've guessed that a shortage or supply shock of a necessity (such as oil, natural gas, food, or water) would do the trick. People would hoard necessities or stores of wealth that can easily be traded for necessities. Andy Xie, whose work we've enjoyed reading since he was a Morgan Stanley analyst, has recently presented a theory that sounds awfully similar to our own.
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Washington's Blog: Bottleneck Theory of Inflation

Andy Xie has an interesting theory about inflation.

Specifically, Xie argues that bottlenecks can form in certain asset classes - such as oil - even in a weak economy, which can lead to inflation:

[Suresh]

Bloomberg: Bernanke Low Rates ‘Poison’ to U.S. Economy, Xie Says
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Fiscal stimulus worldwide restored stability “temporarily” and may be inflationary, said [Morgan Stanley chief Asian economist Andy] Xie, now an independent economist. Asset-price increases are also making a “significant contribution” to global growth, mostly in emerging economies, and industries such as property, automobiles and commodities, he said.

‘Too Expensive’

“The policy consensus to prop up the global economy with stimulus will continue until inflation takes off or governments are broke,” Xie said. “This strategy is too expensive to last.”

Inflation will likely become apparent in 2011, and a “vicious wage-price spiral” could take place the year after, Xie said. He said the lag between money creation, which happened last year, and inflation may take more than 18 months.
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“Inflation would scare central banks into tightening dramatically in 2012, which would pop the current asset bubble,” Xie wrote. “By then the global problem would be more serious than now. In addition to the leverage problem in the household and financial sectors, the government sector would also be hugely levered then.”

The trillions of dollars that governments are spending is “buying some time,” Xie said. One of the risks is that governments may not have enough money to “cushion the pain during the coming economic restructuring,” the economist wrote.

“The whole world is drinking poison to quench the thirst,” Xie said. “It may feel like relief now. The sickness will strike in 2012.”
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

Deflation will be the major storyline through 2011 or so for a combination of reasons. First, the Federal Reserve will temporarily cut back on quantitative easing programs starting in March, thereby reducing or at least slowing the growth of money supply. Second, bank lending will fall as more and more homeowners and commercial property owners become delinquent on their mortgages. Delinquencies and outright defaults will cause the values of those mortgages to fall. As the values fall, then banks will need to deleverage to maintain capital adequacy.

However, the mainstream media will trot out the storyline that deflation in 2010 is no longer an issue. The mainstream media's storyline is a headfake. In the Financial Times article below, St. Louis Federal Reserve President James Bullard mentions how the Federal Reserve is now more sensitive to inflation and evidence of such in the form of asset bubbles. Ironically, he makes no mention of the asset bubble in U.S. Treasury securities, at least partially fostered by the Federal Reserve.
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Financial Times: US deflation no longer seen as a risk

... James Bullard, a voting member of the Federal Reserve’s key policy-setting committee ... [and] president of the Federal Reserve Bank of St Louis, told the Financial Times in an interview that his preoccupation throughout 2009 had been deflation, but the risk had “passed”.
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He added that, although it was not time to tighten policy, members of the committee would weigh in their decisions factors other than inflation and unemployment. Factors to consider would include asset bubbles.

“I think they’re gaining weight with many people because of the bad experience we had in the aftermath of the last recession, the housing bubble and how that really has blown up and caused so many problems,” he said.
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The broader post-crisis economy was “on track” with its recovery, he said. “It’s not a real strong recovery but that’s what we had predicted anyway. But it will be above-average growth for the first half of 2010 and we’ll probably see some positive jobs growth in the first part of 2010 here.”
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

This guy said as recently as February that there was no risk of deflation.

We're a Kondratieff Wave Winter. K-Wave Winters are characterized by deflation, i.e., a contraction in money and credit relative to available products and services. Per John Williams' calculation of M3 money supply, we see that the M3 money supply is contracting at least since the end of 2009.



Credit supply is probably falling even faster as banks hoard cash instead of lending it, contrary to what Federal Reserve Open Market Committee Chairman Ben Bernanke's creditism theory would predict.

Now, consider Ambrose Evans-Pritchard's recent Telegraph commentary entitled "Drip after drip of deflation data."

[Suresh]

Zero Hedge: [Blank] The Deficit (Or Will The Deficit End Up [[Blanking] Us?)
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Hyperinflation is not simply money-printing: Rather, it is when no amount of money will get you what you want. Zimbabwe-style hyperinflation is an example of government money-printing run amok. The Zimbabwe example gives us the mistaken sense that hyperinflation only happens in “disorderly printing” regimes. But that’s not the case.

Chilean hyperinflation in 1973 (which led to the September 11 coup), or Weimar style hyperinflation (which led to you-know-who), are more indicative of what I’d call “scarcity” hyperinflation: Both are examples of when the scarcity of basic commodities suddenly and abruptly leads to a complete loss of faith in money—the belief that no amount of money will get you what you want or need.

That’s hyperinflation.

2008 Deflationists (of which I am a member) argued that after the credit crisis, there would be a deflationary trough. The reasoning of the 2008 Deflationists was, credit should be considered as part of the money supply—so when credit contracts sharply, as happened following the banking crisis in ’08, then that’s the same as if total money supply had contracted. A constriction in the money supply obviously leads to deflationary pressures: Less money is available for the same or more goods. Hence prices fall to meet lowered demand. Hence wages fall as business incomes fall. Hence less money. Hence downward spiral.

As the 2008 Deflationists predicted, today the U.S. economy is in a deflationary trough—I am certainly not arguing otherwise: The evidence is all around, and too obvious.

But what I am saying is, our current deflation can trip over into hyperinflation at a moment’s notice. The stumbling block—the thing that could trip us over from deflation to hyperinflation literally overnight—is The Deficit.

Not just the Federal shortfall itself, but the policy implicitly embodied by The Deficit: The belief that all you need to do is throw money at the problem—open up as many liquidity windows as needed, or expand Federal spending as much as necessary, to prop up those twin aggregates I mentioned before, aggregate demand and aggregate asset value.
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If I had to make a prediction, I’d say that the immediate trigger for a hyperinflationary catastrophe will be a sudden and unexpected commodity spike. It won’t necessarily be big, but it’ll be flashy—enough to cause a panic.

This will be the opening stages of hyperinflation: It will be a market panic, and it’ll be fast.

At the next panic-inducing crisis, American public-policy makers will once again turn to The Deficit, providing more liquidity and more stimulus—and this will make the financial markets realize that the fiscal shortfall is unsustainable: It will be obvious that all those Treasuries cannot be repaid—or if they are ever to be repaid, it will be done by the Fed via surreptitious monetization. In other words, a dollar with lesser value.
Thus, everyone will want to be the first to get out of the dollar—and everyone will want to be the first out the door all at once.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.

[Suresh]

The Big Picture: Quantitative Easing (QE2 & QE3)
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Fed Chairman Bernanke and even his hawkish colleague, James Bullard, set the table in July for QE2, as we suspected the Fed would eventually have to do.
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In the US we expect the Fed to buy more MBS and, perhaps, CMBS receivables from creditors, ostensibly freeing their balance sheets to eventually extend more credit. The Fed would pay creditors for the mortgages with newly-digitized money.
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As it stands and citing all appropriate disclaimers, we now expect a total of three rounds of quantitative easing.
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The bigger inflation event (QE3?) would use newly created base money for the immediate benefit of debtors. Sending checks to indebted homeowners made out to their creditors would be an example of quantitative easing that would be popular among the masses and economically stimulative. It would allow a new credit bubble to expand and prices of goods, services and assets to increase. We think this form of QE — broad debt socialization – is inevitable. It would require coordination among central banks and fiscal policy makers, which would demand a general acknowledgement that nothing else would work. (This would not be a de-leveraging event, but a transfer of debt from private to public balance sheets.) Frankly, we do not see this materializing yet.

Meanwhile, we think the upcoming increase in the US dollar monetary base will be far less effective than the initial round. QE2 should promote increasing global wealth transference from cash and financial assets in paper currencies to precious metals and finite natural resources.

We would expect the general level of stock markets to oscillate around current levels for an extended period, until the third round of QE is imminent. We would expect the same for bond prices and yields. Once the markets begin to discount QE3, we would expect stock prices to rise. The fate of sovereign and tertiary bonds prices is not as predictable going into QE3. Yields would naturally rise if it is perceived that price inflation would eat into the purchasing power of future principal and interest payments. However, sovereign yields might actually fall and stay low were there to be a formal currency devaluation (see the last section, below).

All the while we expect precious metals, agricultural, basic materials and energy prices to climb consistently through QE2 and QE3. We believe the bull market in precious metals will run faster and higher than consumable commodities and begin to fade only after a third-wave parabolic price shift higher. We think the bull market in consumable commodities will kick-in significantly once consumer confidence and significant (price-generated) nominal output growth returns.
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Suresh

Please feel free to agree with or critique the article excerpts and our comments. Also, please post excerpts from current articles that you've read and which may help all of us get a more complete macroeconomic big picture.