Inflation now, deflation later
December 26, 2003
Jim Bradley hedges interest rate risk and coordinates loan sales for Dollar Mortgage Corporation , a nationwide mortgage bank headquartered in Southern California.
Credit cannot grow forever, and the debtors eventually will be unable to pay in real goods. That can be resolved by inflation or deflation. But it will be (and has been) inflation first, because that is politically acceptable in comparison to the massive restructuring needed when new credit becomes unavailable. The government can and will be the "lender of last resort" until the political will is available that will halt the inflationary process.
And that will likely happen, I believe, when the global public finally rejects U.S. government money severely enough that the foreign central banks are forced to halt their competitive devaluations and the Fed here is in turn forced to reign in money supply increases. Then it will be deflation.
The Fed has already stopped the speed of the credit expansion, because M3 at an annual rate (monthly change x 12) is falling by 10-13%, but at the YOY level it is still above 2002 by about 6%+. That indicates that the recent removal of "long bond purchase" threat by Bernanke caused a major tightening in the market. Mortgage production is off by 65% (Amazing, isn't it?) Mortgages are the current center of credit expansion.
In that respect, remember the dollar's value is determined very much by foreign trade and the Fed. 35T-40T dollar of U.S. debt is not "covered" by U.S. yearly GDP of 10-11T, but by world trade (31T+), 70-80% of which is settled in dollars, as dollars tend to hold their value; but dollars won't hold their values at interest rates of 4.5% (net mortgages / 10 year treasuries) if the dollar continues to fall by 20-30% YOY. It is important to realize when holders of dollars bought dollar assets. A recent fall is not necessarily indicative of investment loss, but additional downside from here certainly would be.
The Fed can pull us back by tightening -- if they do, it will cause significant deflation-like forces in the U.S. before private employment has fully recovered. It is likely the Fed is in a holding pattern for the 2004 election year.
The fact that gold remains high but M3 is shrinking is significant. It means that even though credit is decelerating for the U.S., the dollar is falling and gold continues to rise (add on top of that the dollar is falling even though Japan is supporting it to the tune of a $1 Trillion per year buying rate). I think that means the Fed has a short-run choice between monetary inflation and recession: they'll choose mostly monetary inflation for 2004, hoping the price inflation will be deferred. The long run choice there is only one alternative: recession as credit expansion must slow, halt, or reverse. The market will make the Fed act at some point.
Bottom line, until the pain of monetary inflation is felt severely in the U.S. and the political timing is right, I suspect the inflation will continue, but at varying rates so that the Fed “manages” public perception of the inflationary process. The current inflationary cycle started in real estate, now all other prices will likely rise if gold keeps moving up. Theoretically, the government can ALWAYS cut taxes and / or "spend more" (as the Fed buys the bonds with new money) to generate a positive inflation rate. Practically, they will do so until the pain of that policy outweighs the political repercussions of the correction.
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