inflation vs deflation
Post from Veg on my board on the FOOL
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A Belgian respected and retired analyst, Roland Leuschel, declared a couple of days ago, that inflation was very probable. He reminded us that in 1968 the German chancellor said that inflation was dead. Back then inflation was 1,3 %. Only five years later some countries noted double digit inflation.
So if comrade Roland says so, it must be true.
However instead of strengthening my belief in an inflation scenario, it had the opposite effect on me. I started rethinking everything and ultimately changed my mind and became, at least for now, a believer in the deflation scenario, something that puts me the camp of Plunger and Mish and drives me away from consensus.
The alteration started with a simple analogy.
You can get burnt as well from extreme cold as from extreme heat. Both burnings show the same characteristics (although they told me that burns from cold are more difficult to treat).
However the circumstances are opposite and depend on the temperature.
What is needed to change the environment is a change in temperature.
You can add hot water to the environment where the ice cubes are, if the extreme cold temperatures remain, the hot water will cool down and eventually change into ice too.
On the other hand you can pour ice cold water in a boiling environment but here too when the temperature remains very high, the cold water ultimately will evaporate.
The temperature in the analogy is nothing more than the long term economic trend.
Let's first wage the arguments.
Since last summer the danger of deflation ebbed away. A large majority predicts higher nominal long term interest rates in 2004 and 2005. Although not impossible, it becomes more and more improbable.
The hawks of a rise in inflation, like Roland, point at the high growth in the US and the rising commodity prices, and for the latter they refer to the seventies. Moreover precisely because of these elements, they believe the Fed will hike, which is one more argument for a renewed growth cycle and rising inflation.
This circle reasoning bothered me and forced me in a comparison with the fifties and sixties.
IMO every analogy with the seventies is wrong. The seventies were the final phase of inflation waves that started in the fifties. The rebuilding of Europe or better the world after WWII, the broad application and distribution of technology that existed already in the twenties and thirties, the baby boom in the sixties, the rise of the US as the only real (and back then good) superpower, and so on, were elements that contributed to an inflationary environment. In this context it is rather silly to lift out only the rising commodity prices to forecast inflation.
We, or better I, often make the mistake of underestimating the inertia of the long term economic trend.
If memory serves, most of the “themes” that favor a deflationary environment have been mentioned by Plunger (General Outlook). But I'll do it with my words and will try to add some elements and make my own timeframe.
Even in a strong growth scenario, inflation will not appear. The overcapacity in the world, the intense battle for market share, falling labor costs per unit are rather proof that we're now in the final phase of long term deflationary period that started way back in the eighties.
The aforementioned environmental circumstances make it highly unlikely that rising commodity prices will translate themselves in higher prices of goods and services in the coming quarters or years.
Though this may be the case against inflation then what is the case for deflation?
The present combination of low and even falling inflation, an average sub-trend growth in the world (since 1999) and in the US (since 2000) and the high debt rate and overvalued assets, form a poisonous cocktail which can lead towards deflation. A deflation caused by falling prices of shares, real estate and corporate bonds accompanied by a reduction of outstanding debt, bankruptcies and conversion of debt in shares. All this can/does result in an absolute drop in prices.
We already noticed that Greenspan's favorite measure of inflation, the GDP deflator, dropped to 0,7 percent in December.
The initial deflationary trend has been stopped by the Fed and the US government which added hot water to the environment (aggressive lower interests and fiscal stimulus). First the drop of the stock market was neutralized by staggering housing prices, later the stock market recovered and corporate profits revived due to partly government spending, low interest rates and a lower dollar. But all this is only delaying the inevitable.
Because none of these elements are fundamental! Share prices are historically overvalued by 50 to 70 percent and housing prices are overvalued when compared in the historical relation with rent prices.
Therefore the price deflation triggered by asset deflation still has to start.
On the other side, the debt side, it ain't any better.
The US government debt doubled since 1993 and is now 300 percent of GDP. Mortgage debt doubled in eight years, consumer credit did the same in nine years, corporate debt in twelve years and the debt in the financial sector also doubled in six years (one reason why I'm skeptical about the latter).
In general we count on strong growth combined with inflation, to get out of this mess, but isn't it precisely the overvaluation of assets and the huge debt that is the crucial obstacle to achieve our goals?
Deflating assets will urge consumers to save more and consume less, which will reduce consumption and decrease the chances of inflation.
The circle reasoning presented by Roland & C° can equally be reversed and on top of it we do have a lot more fundamental arguments to sustain it.
Bernanke too believes that government still can induce inflation by loose monetary policy. And yes, it has been done in the past. But here again and I repeat, the analogy with the past doesn't work out necessarily. Environmental fundamentals will ultimately determine the outcome.
Banks must be ready to lend money and the horse must be willing or able to drink.
The drop in the money supply since 2003 could be an omen.
But the story doesn't end here. There are several other elements to consider.
The Fed funds rate for one year paper has a negative real interest rate.
Normally we have negative real interest rates when inflation is rising strongly (compare with the seventies) but now we have negative real interest rates when interest rates are very low!
From a practical view the Fisher theory isn't very useful but IMO it does signal the characteristics of burnings. And to me it looks more obvious that at these very low interest rates, the burning is caused by cold and not by heat (though we won't notice the difference by looking at the injuries).
Another element is the steep yield curve measured as a ratio of the 10 year treasuries (4,13) vs 3-month paper (0,90) or deposits (1,06). The ratio is about 4 or double of the steepest curve measured in the past 10 years (in 1992 and 1993).
Historical evidence shows that this predicts strong GDP growth but I don't think this suits the present situation. As mentioned before the circumstances for a self feeding long term growth are not present.
As we're now in the Ice-period we better reverse our reasoning and instead of seeing the short term rate go higher to reduce the steepness of the curve, it is more likely that the curve will normalize by falling long term rates. Fundamentally the causes for lower rates (higher prices of bonds) will be falling share prices, a higher share of investments in government bonds by pension funds and investments for proper purposes by financial institutions.
The steep US curve is an example of how relations have changed, mainly due to the Fed's exceptional and aggressive monetary diarrhea.
Or in plain English, the temperature of the added hot water will drop to the level of the environment and turn into ice.
Varia
Do we also notice the formation of a convincing bottom in the 10 year US, European and Japanese Treasuries? If yes, then the danger of deflation has increased.
And what about the low interest rates in other countries. Sweden (2,5 % lowest rate since 1945 – and economists telling us it cannot go lower), Norway, ….
I do have the impression that today the average investor is still willing to take some risk to increase his return. Well risk aversion will increase after some good spankings.
A word on employment
Here too we recognize a self fulfilling prophecy. If employment rises the danger of deflation will disappear. However today I fear that the employment rate will depend on which way we will go, inflation or deflation, and not vice versa. In case we're heading for deflation unemployment will increase and deflation will accelerate.
Again, and this is getting really boring, the circumstances are not present for an increase in employment. So you won't get it!
Conclusion
The Fed is not facing a dilemma. Even without an interest hike, things are looking bad. The vulnerability of the economy due to the large debt burden and the danger of a falling consumption, leaves them no choice.
In this context it doesn't matter what the future market tells us.
I estimate the chances of reaching the high levels of bond prices (June 2003), again as realistic.
Moreover we cannot pretend that long term interest rates of 3,10 – 3,46 are historically exceptional. In Japan the 10 year treasury rate is 2 % since 1997 and between 1935 and 1955 US treasuries (as well the 10 as 30 year bond) were beneath 3 % (during 1939 and 1950 even under 2,5 %).
Heading towards Euro-bonds
I assume that in the near future the dollar will fall further versus the euro (long term outlook) and that the government deficits in the US will remain higher than in Europe.
A dollar crash could cause a sharp increase in the long term interest rates, but I guess that this trend won't hold long in a deflationary environment.
The Economist “Special report Currencies” writes something similar (last paragraph): “Not only do artificially low bond yields appear to offer false signals that America's budget deficit is no cause for concern, but by holding down mortgage rates (which are linked to bonds) they are also prolonging an unsustainable boom in consumer spending and borrowing. This benefits America in the short term, but allows even bigger imbalances (in the shape of domestic debt and foreign liabilities) to build up in the long term. To contain these debts will eventually require a far sharper collapse of the dollar, a steeper rise in bond yields and a harder economic landing”.
The only difference here is that IMO the steep rise in bond yields won't hold long.
I will also avoid the emerging markets. An overheating Chinese economy, a Japanese economy largely relying on the Chinese and the US markets and so do the other Asian economies, and the pegging of their currencies to the dollar, makes me wary.
On top of that bonds from emerging markets are already priced for perfection (see also an article in the Economist).
Therefore I will mainly invest in euro-treasuries.
Timeframe
Difficult to comment on this one!
But here I must for an overall look rely on historical events (and be vigilant every day).
The presidential circus … oh sorry, the presidential cycle suggests that the year 2004 will be … euh let's say fruitful, and that we'll get the bill of excesses presented in the years 2005 and 2006.
The presidential cycle is nothing more than what Madame Le Pompadour (the mistress of the French King Louis XV) once said: “Après moi, le déluge!”.
So far Bush seems to be fitting well in Madame le Pompadour's corset.
Anyhow I don't think I must hurry.
Well I'm forgetting gold and silver of course. A brief word!
There seems to be some consensus here too. The price of gold only rose in two currencies, the Yen and the Dollar. Not surprisingly when you look at their interest rates and their monetary policy. In euro the price of gold dropped by 3 %.
The consensus is that the price of gold will also rise in euro, once the ECB cuts rates and that will happen when the dollar reaches 1,40.
My change of mood tells me today, that it won't take that long. Gold could precipitate the movement.
What I also could do is take interest bets like Plunger and Mish, but then I need to study and at least understand the price mechanism of the interest rate futures and wrap them in my timeframe. No time for the moment, perhaps later.
Already way too long.
Cheers
Veg. |
