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One of
the most hotly debated topics among financial talking heads these days is,
"Deflation or inflation, what is it going to be?"
There
is no question that we are currently experiencing asset price deflation and
economic slowing. But we, the editors of The Casey Report, see this as a
transitional phase. In our analysis, the truly extraordinary and historic
levels of government spending and bailouts being deployed to keep the economy
afloat are certain to lead to inflation in the not-too-distant future.
While
our long-term view remains solidly in the inflation camp, over the past four
months, the U.S.'s financial problems have caused deflation in many important
asset classes. Put another way, a reduction in asset prices amounting to
about $14 trillion (in housing, equities, etc.) is bigger than the
government's countervailing actions of around $3 trillion -- the total, so
far, arrived at by combining the measures taken by the Fed with the federal
government bailouts.
But
there are important differences between a sharp collapse in asset prices and
the potentially leveraged stimulus packages.
The
Fed's actions, if taken in normal times, would be multiplied throughout the
banking system as banks used the new money to increase their lending and, in
so doing, leveraged the funds throughout the entire economy. This time
around, however, while the Fed has been extremely accommodating to the banks,
even going so far as to make direct loans to them, the effect is moderated.
That's because of tighter lending standards, the need to replenish capital,
and the demise of many complex structures, which were previously available
for securitizing and selling loans on to others.
As a
result, the banking system as a whole is not responding to the stimulus. It
can be thought of as pushing on a string. Simply, as large as the stimulus
has been to date, it has not yet been enough to offset the effects of the
economic collapse. The resulting deflationary pressure increases concern over
a downward spiral in the economy.
Another
way to view this is that consumers and businesses alike are now anticipating
deflation, which makes saving and survival the primary goal (in an inflation,
spending becomes the primary goal, unloading the money before it can lose
value). Of course, a cutback in spending and demand drives down the price of
things, at least temporarily.
But
the longer-term expectation is that Bernanke's assertion - an assertion now
backed up by action - that the government can and will print new money to any
extent needed is the more important force.
As
long as there is evidence of serious economic collapse, it can be expected
that the bailout programs will be ratcheted up. And, to the extent that the
public expects deflation - and so businesses reduce prices to raise cash and
reduce inventories - the wave of price inflation experienced in the spring of
2008 will be moderated. But within the seeds of that positive are the very
big negatives that the government, seeing that its extraordinary money
creation is not being evidenced in rising prices, will be emboldened to go
even further.
This
is of great importance because, unlike in the 1930s, there is no limitation
on what the government can do, because there is no gold standard to enforce
monetary discipline. Instead, the world is afloat on a sea of massive new
government spending and credit facilities. After a lag, the stimulus will
perform the expected actions of reinstating credit and debasing the currency.
But never lose sight of the fact that the government is creating money out of
thin air. Some call it bailouts, we would call it legal counterfeiting on an
epic scale.
In the
New Deal, FDR created the FDIC and guaranteed bank deposits, set minimum bank
deposit rates, and brought the discount rate to almost 0%. He cut the
dollar/gold exchange rate from $20.67 to $35 and confiscated gold; i.e.,
devalued the dollar by 40%.
While
the beginning of the collapse from too much credit was parallel to the
previous experience of the depression, the response today is different. The
size of the monetary stimulus and the risk to the dollar from foreign holders
-- who can also see the implications of the out-of-control deficits --
strongly argue for a return to inflation much sooner.
How
much sooner? Impossible to say, but remember: deflationary or inflationary
fears are not the independent agent that will determine whether or not we
will see inflation (though, in the intervening phase, they will certainly be
an important economic driver). The Federal Reserve is throwing everything it
can at the financial markets to fight deflation. As you can see in the chart
below, the Fed has doubled the size of its balance sheet since September.
On
December 16, the Fed cut interest rates to a range of between a quarter of a
point and zero. That is lower than ever in the 94 years of their existence.
And they promised in the accompanying announcement to provide additional
funds to "stimulate the economy through open market operations and other
measures that sustain the size of the Federal Reserve's balance sheet at a
high level... the Federal Reserve will purchase large quantities of agency
debt and mortgage-backed securities to provide support to the mortgage and
housing markets."
At
this time individuals and companies alike are sensing deflation and, as a
result, are raising cash... in the process deleveraging the extreme debt
loads. That is causing downward pressure on asset prices and, soon, a serious
contraction in the economy as more and more companies lay off workers and
cancel spending. This will not be a happy holiday season. And it will be a
long-term recession and maybe even a protracted depression.
But
the fact of the extraordinary deficit spending is there for all to see and,
over time, more and more will see it. And, more to the point, understand it.
In fact, thanks to the Internet and always-there financial media, the shift
in sentiment can happen almost on a dime. Slowly at first, and then faster,
fears over inflation will return, but this time they will be well founded.
The
economic downturn could be protracted, but that does not mean that the
deflation will be protracted. Instead, once we are through this phase, we
expect to see poor economic conditions, but against a backdrop of rising
inflation. Stagflation is a word that remains in our vocabulary.
Inflation
or deflation - whatever the current market trend, there is a way to play it.
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Bud
Conrad is the chief economist of Casey Research, LLC., providing fiercely
independent analysis and investment recommendations for subscribers in the
U.S., Canada, and over 150 other countries around the world.
Bud Conrad
www.caseyresearch.com
Bud Conrad is the chief
economist of Casey Research, LLC. and a contributor to the Casey Energy Speculator (CES), a monthly newsletter dedicated to uncovering deeply
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