The inflation – deflation debate redux


I’m getting a lot of mail about the Rosenberg post and my mea culpa on inflation. To be blunt, a lot of you think I’m out to lunch and Rosenberg is too — after all inflation is over 5% and that’s just the bogus CPI measure our governments release.

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But, alas, there is method to my madness on inflation. Here’s my thinking:

My baseline argument is that the world’s central banks were way too easy with monetary policy after the recession of 2001 and 9/11. Basically, they saw a deflationary threat and panicked. The result has been inflation.

To be sure, there was plenty of inflation before 2001 — it was just channeled toward asset prices instead of consumer prices because the deflationary forces of China, India and the collapse of the Soviet Union brought a lot of workers into the global capitalist world. So, before the so-called deflationary threat, all of that excess money bid up only asset prices because global wage arbitrage kept it from hitting consumer prices (think DVDs, LCD screens, toys, clothes and so forth — all made in China).

However, once the global housing bubble collapsed, the asset class of choice became commodities and those same inflationary forces started to work their magic in the commodities sector. Unfortunately for central banks, commodities are an asset class that feed right into consumer price inflation. So the central banks have not had the same ability to reflate after the housing bubble because inflation is now popping up in consumer prices. As an inflation hawk, I was pretty vocal in calling out against the Fed’s easy money policy (I still think it’s wrong because it’s basically surreptitiously stealing money from citizens through devaluing the currency).

Funny thing is though — inflation has a way of killing consumer demand; it’s called demand destruction. So, the rise in food and oil prices has cratered demand for oil and really undercut consumption to the point where the global economy is in recession. Spain, Denmark, Germany, Italy, the U.S. and Canada have all recently posted negative or near zero GDP numbers. Japan looks to be in recession as well. There is no way inflation will continue to rise in this environment unless oil prices go back up due to some exogenous shock.

So, barring an Israeli-Iranian war or the like, we should expect oil to deflate to $100 a barrel and inflation to recede. Remember, core inflation (ex. food and energy) has yet to become too worrying. What does this mean for the global economy?

  1. Expect inflation to push up for a few months due to unfavorable year-to-year comparisons, but then to recede starting near the end of this year.
  2. The rise in oil has already done its damage: the global economy is in recession and this means jobs will be lost and companies will go bankrupt.
  3. Writedowns from the housing bust will continue unabated because of the faltering real economy. This means stress for the financial sector.

And ultimately this confluence of events means credit availability will be in short supply. No credit = no growth = no inflation. In fact, financial services companies will be deleveraging i.e. cutting lines of credit to companies and individuals in order to shrink their balance sheets.

For example, if you were Morgan Stanley and the U.S. economy was headed for a protracted downturn would you

a. increase credit lines to homeowners, hoping it would single-handedly pull the economy out of recession?

b. restrict credit to bad companies and those with poor credit as you need to be prudent? or

c. Panic and reduce credit all around, especially HELOCs (Home Equity Lines of Credit)?

As you probably know from reading the news, the answer has been and will continue to be

c. it’s panic time on Wall Street, Bay Street and in the City of London.

The only conclusion I can draw from this is that the lifeblood of our capitalist system, credit, will be contracting and this means deflation is a real threat going forward. While I have been concerned about inflation up until now, the evidence coming out in the last few weeks suggests the global economy is in recession and that deflation is really what we need to be thinking about from here on.

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