DEFLATION HAS ARRIVED
By Bob Prechter
"The deflationary potential is historically large... we risk
overwhelming deflation in every corner of the globe."
- Conquer the Crash (2002)
Virtually everyone - and I do not use that word lightly -
believes that inflation will accelerate. Stock-market bulls
think that the economy is going to boom, bringing
inflation. Economic bears expect an inflationary, if not
hyperinflationary, monetary crisis. Economists believe that
the Fed can inflate at will and is committed to an
inflationary policy. The general population is convinced
that prices of their homes and property can only go up. The
few articles mentioning deflation in recent months have
declared the prospect for it "dead."
This consensus is not merely overwhelming but reflects a
belief as vast and deeply held as a religion. Investment
News in September reported a survey by the National
Association for Business Economics in Washington. It
revealed, "None of the respondents to the May survey, all
of whom were responsible for making macroeconomic
predictions, predicted a decline in the consumer price
index during the next two years." USA Today confirmed the
fact, reporting, "Not one economist [of 67 surveyed] said
it was 'very likely' the economy would slip into
deflation." That is a consensus!
Against this backdrop of opinion, M3 since September has
fallen over two percent, its largest decline in 60 years.
This is different from a lack of inflation. It is real,
actual, deflation. What's more, M3 has declined despite the
strongest quarter of economic growth in decades, the lowest
interest rates in half a century and a central bank
committed verbally and by action to facilitating the
expansion of credit! There is no interest rate spike or
recession to explain away the decline in the money supply.
The dichotomy between what is happening and what people
think will happen is colossal. Inflation is dead. Deflation
is here, now. The monetary trend is no longer close to the
edge of the cliff; it is beginning to slide down its face.
As this is written, not a single major newspaper, magazine
or TV network has done a story on the dramatic contraction
in M3. People are so drunk with inflationary certainty that
they can't even see that deflation is happening. And if
they do, they don't believe that it is meaningful.
Why is there such a consensus that deflation is unlikely,
if not impossible? Many people believe that the Fed is
virtually omnipotent and can manipulate the money supply
(and therefore the stock market and the economy) at will.
Is that so? On June 25, 2003, the Fed lowered the federal
funds rate for the 13th time in a row, to one percent.
Most observers think that the Fed still has that one
percentage point of "ammo" left. But consider: The U.S. has
a thriving money-market fund industry, which costs one
percent of assets per year to administer. As it stands now,
investors are getting extremely low returns from money-
market funds. If the Fed were to let its funds rate drop to
zero and other short-term rates fell along with it, money-
market investors' return after fees could go negative. This
event would make holding cash more attractive than holding
debt, a situation the Fed surely wants to avoid. The
monetary system appears to have reached the point at which
pesky reactionary forces will come into play if the Fed
tries any more "deflation fighting," no matter what the
mechanism.
Why did I put the term "deflation fighting" in quotes?
Commentators tell us that the Fed is fighting deflation by
aggressively lowering its interest rates, but is that an
accurate assessment? After all, the result of deflation -
its primary outward symptom - is lower prices. And what has
the Fed been doing? It spent over a year lowering the price
of renting money. Within that period, in fact, the Fed
lowered prices more than anyone! It has participated in the
initial phase of the deflationary process as if it were a
merchant on the street discounting its wares to a
disinterested public. It did so in response to slack demand
for its product - credit - just as the auto manufacturers
and others are doing with their products. Deflationary
psychology brings about lower prices, and the Fed has been
lowering its prices. It is powerless to stop the trend.
A persistent decline in the money supply will have
consequences. Some things will have to give. One of them
will be prices for goods and services. To the astute
observer, a change in prices has been in the wind for some
time. The PPI has been flat for three years, and now even
the CPI has had a down quarter. A severe deflation will
also devastate the economy, as it has done in each of the
rare times it has occurred over the past 300 years. With M3
dropping, it should be only a matter of months before the
economy follows suit.
Are economists concerned? Well, besides the deflation
opinion cited above from last year's polls, the only other
time that I have ever seen a 100-percent consensus in a
survey was... a few weeks ago! In separate year-end surveys
of economists, The Wall Street Journal and Business Week
independently reported unanimity that the U.S. economy
would expand throughout 2004. That's right: not one
dissenter. If it is usually wise to bet against a large
majority in finance, what does it mean when there is no
detectable minority?
I think that the continual denials that deflation can
happen, against a backdrop of evidence to the contrary,
appear to be part of a typical social psychological
progression toward a credit crisis, which in turn will lead
to economic contraction. The money supply might rebound for
a quarter or two as the stock market and economy top out
this year, but at the largest degree of trend, the credit
bubble - 70 years in the making - has burst.
In 2001, there was little talk of deflation. Statistics
relating to newspaper stories show that by late 2002/early
2003, it had become a commonly used word, even if most
writers used it simply to dismiss the idea.
The next word that should begin to slide into the public
lexicon is depression. I would like to offer quotes from
authorities on the low likelihood of depression, but my
diligent staff can find literally no mainstream economists,
academics or Wall Street strategists even discussing the
possibility. It is too remote even to mention! The term
"depression" is where the word "deflation" was a few years
ago, i.e., outside the general consciousness. Although no
one is using that term now, in coming years it will be
everywhere. The first phase will be widespread insistence
that a depression can't happen, which will be a big clue
that it is happening.
The two "d" words at the end of the subtitle to Conquer the
Crash, i.e., "Deflationary Depression," were anticipatory.
The book was published at a time when the likelihood of
these two events occurring was (and still is) considered -
as one economist said at the time about deflation - as
remote as "being eaten by piranhas." My advice: Keep your
toes on the riverbank.
Regards,
Bob Prechter,
for The Daily Reckoning |
