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To: Box-By-The-Riviera™ who wrote (98468)	4/28/2001 2:23:19 PM
From: NOW	Respond to of 436258

Can secular deflation be warded off ? Posted By: IRE Date: Saturday, 28 April 2001, at 10:01 a.m. In Response To: Unbelievable - Looks Like Massive Inflation (Albertabear) Albertabear, I always enjoy your posts and tend to be in your camp although I'm not sure I'm quite as cataclysmic in my longer term views. The issues you raise here are really the crux of the whole issue . . . . namely, can secular deflation be warded off in a highly leveraged credit based economy? Clearly, I don't know the answer -- if only! -- but I do have a few thoughts which I'd like to share: 1. The current growth of the credit aggregates doesn't necessarily mean the Fed is winning or will win. Much of it is related to the massive levels if refinancing we've seen of late and a good deal may also be the result of desperate attempts by corporates to sustain some liquidity in the face of falling revenues, rising costs and intense competition from global overcapacity. They are almost certainly drawing down previously arranged lines of credit at a furious pace. To the extent that these either replace commercial paper or add to the level of outright credit the aggregates are correspondingly inflated. 2. You've no doubt noticed that long rates have not only ceased going down but have actually backed up fairly significantly in recent weeks. This means the putative gains from cuts in short rates are being undermined at the long end which is what really matters. Mortgage rates, for example, are now higher than at the start of the year despite the Fed Funds rate being 2% lower. The lower short term funding is also no doubt encouraging a lot of speculative carry trades which may explain a good deal of the compression of spreads. However, if long rates continue to deteriorate this will become a very expensive exercise indeed. 3. The sheer amount of credit outstanding -- much of which is longer term -- means that increases in long rates causes very significant capital losses. This too is a negative wealth effect and is potentially at least as important as the stock market. Should the market become convinced that the Fed is "going for broke" then there is in my view a very good chance that the resulting losses on various fixed interest instruments will dwarf any stimulative effects from the easings. This would be when the bind really hits. I have little doubt that the Fed would then move to active monetisation of all kinds of credit instruments but my guess is at that stage the reaction of smart players around the world will simply be to say "yours" . . . . you're welcome to them. 4. Behind all of this domestic excitement lies the constant question of how foreigners will react. It's worth bearing in mind that the US combination of high gearing, large and growing external deficit and heavy external indebtedness bears more than a little resemblence to the Asian nations pre 1997. Just because the economy is huge doesn't mean that it's immune to gravity. Last year, for example, the US is estimated to have absorbed some 80% of the world's savings. The dollar is really the point of greatest vulnerability since the authorities have very limited foreign reserves to support the dollar. They can generate any amount of dollars should they decide to go for broke but without the active cooperation of foreign central banks the can't buy them. I have real doubts about how far foreigners will be willing to go to back the US. They have not, after all, made a lot of friends in recent years. 5. Asset prices whose height precludes their paying their way are ultimately hugely deflationary. It's not just a mood or a liquidity thing -- although these can dominate for a long time as we've all experienced! -- since without a constant infusion of fresh liquidity they run down like a battery toy. The telecoms sector is arguably the perfect example of this dyamic at work. As of course was the largely absurd dot.com universe. I doubt whether there are enough uninformed players to plug the gap for very long now that the reality of risk has finally been let out of the bottle. No, on balance I suspect we are witnessing a brief period of Indian summer before the chill winds of winter whistle in again in full seriousness. The sheer rate at which the Fed is dropping rates and uttering encouraging noises confirm the underlying severity. Hope -- the last sad vestige of the mania -- is giving their desperate moves some temporary traction but I suspect it's all extraordinarily fragile. As always, it'll be most interesting to watch. IRE bearforum.com