Alarm bells ring at Fed (deflation alert)

Financial Review ^

[freeper12]

It was a conference to mark Milton Friedman's 90th birthday last month, and who should give the toast to the world's most famous monetarist? A governor from the US Federal Reserve, naturally.

The man from the Fed, a monetary expert in his own right, Ben Bernanke, delivered a dense, 10-page tribute to Friedman's contribution to modern economics, then this punchline: "Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton ... regarding the Great Depression: You're right, we did it.

"We're very sorry. But thanks to you, we won't do it again."

A couple of weeks later, seemingly following through on this pledge, Bernanke delivered an unprecedented speech in Washington DC. The title: "Deflation: Making sure it doesn't happen here."

It was the Fed's emergency plan, the economic equivalent of the The Worst-Case Scenario Survival Handbook

Bernanke laid out the extraordinary measures the Fed could take - including buying assets from private companies - if the US economy fell into that condition people associate most closely with the Great Depression - deflation, a fall in the general level of prices, the opposite of inflation.

If inflation is too much money chasing too few goods, then deflation is too little money chasing too many goods.

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How close is the US to deflation?

Fed chairman Alan Greenspan told anxious members of Congress in October that "we are not close to the deflationary cliff". But how good are his forecasting skills? The Fed, by its own admission, utterly failed to foresee Japan's slide into deflation seven years ago.

And a solid core of serious analysts now believes it to be a very real risk. The Fed's own behaviour betrays a distinct unease. A month ago it cut the key official interest rate by an aggressively large increment - from 1.75 per cent, already the lowest in over 40 years, to 1.25 per cent.

Fed officials have called that move insurance. Although the financial markets think there is little chance that the Fed will cut rates again at its policy meeting this week, "the Fed is, I won't say panicked", says Steve Roach, economist for the investment bank Morgan Stanley, "but it is very much on alert".

The decision by President George Bush to replace his economic team last week is another indicator that American officialdom is alert to the need for decisive action to keep the economy from quicksand.

As the Fed's Bernanke says: "Sustained deflation can be highly destructive to a modern economy and should be strongly resisted."

Consider the evidence of deflation so far.

The broadest measure of price pressures in the US economy - the gross domestic product deflator - is barely above zero. In the year to the end of September, it was up by 0.83 per cent, its feeblest in half a century.

"The essence of deflation is that business leaders know they do not have pricing power," the ability to raise the price of their products, points out Wayne Angell, a former governor of the Fed and chief economist for the Wall Street investment bank Bear Stearns.

And the prices received by US firms overall have declined in each of the past five quarters, the longest run in more than 50 years. For the latest quarter, they were down 1.3 per cent.

At first, and sometimes for years, executives think that this lack of pricing power is temporary, due to a downturn in the business cycle, Angell says.

"They expect that pricing power will return with recovery." With deflation, it doesn't. "This is precisely what is happening in the US economy today."

Consumer prices in the US are still rising - by 1 to 2 per cent a year, depending on the measure. But David Rosenberg, an economist in the Canadian office of the US investment bank Merrill Lynch, points out that the price of 40 per cent of the hundreds of items that go into the basket to make up the consumer price index are falling.

Indeed, all the inflation in US consumer prices is coming from only five areas that make up a quarter of the index - housing, tobacco, car insurance premiums, hospital services and tuition.

"There's a compelling case for deflation," says Morgan Stanley's Roach. "We are in a rarefied and highly dangerous period."

The two top-most international finance officials in Japan last week took the warning even further. They declared that it was not just a danger facing the US - it was a risk to the entire world economy.

In an unorthodox move, the Vice-Minister for International Affairs at Japan's Ministry of Finance, Haruhiko Kuroda, and his deputy, Masahiro Kawai, put their case starkly.

"Monetary policymakers around the word are still fighting the old enemy of inflation, not the new foe of deflation," they wrote in the Financial Times.

"There is an urgent need to switch to global reflation in order to avoid a deflationary spiral." They called on the Europeans, Americans and Chinese to join Tokyo in heading off a global deflation. And the Japanese know something about contemporary deflation - they pioneered it.

The mainstream of US forecasters does not foresee deflation in the US. But then again, the mainstream does not have such an enviable record of forecasting - the consensus of US economists conspicuously failed to foresee the length of America's boom of the 1990s, and completely missed its 2000 bust.

What of Milton Friedman's school, the monetarists, whose believe that the supply of money is the key to inflation and deflation?

A respected US monetarist, Allan Meltzer, professor of political economy at Carnegie Mellon University and author of a new book, A History of the Federal Reserve, dismisses the possibility of deflation as nonsense.

"It's just bad thinking by badly trained Wall Street economists," Meltzer says. "I don't think any competent economist can make the case for deflation with M2 [the base money supply] growing at 8 per cent year on year and the economy expanding.

"You hear it from that Morgan Stanley guy, and his policy is being able to say, if something goes wrong, 'See, I told you so!', and he hopes that people forget the 800 times he was wrong."

What does the Morgan Stanley guy - Roach - have to say about this?

"I don't want to call a guy like Allan Meltzer simplistic ... but he's pretty consistent with his monetarist framework.

"With all due respect to him, the money supply may be growing, but there's no guarantee that it will go into consumption or prices. It's a circuitous route, at best - especially in an overindebted economy.

"Money can go into debt or saving; if you print enough of the stuff it will eventually spill over, but it's a long and arduous path."

It should also be pointed out that Roach's forecasting record is quite good, and better than most.

But even if you disbelieve the case for deflation, the most persuasive case for vigilance comes from the Fed itself.

An important research paper by 13 Fed staff economists, titled Preventing Deflation: Lessons from Japan's Experience in the 1990s, says: "Japan's deflationary slump was not anticipated. This was true not only of the Japanese policymakers themselves, but also of private-sector and foreign observers, including Federal Reserve staff economists.

"Moreover, financial markets had no better handle on the economy's prospects ... The failure of economists and financial markets to forecast Japan's deflationary slump in the early 1990s poses a cautionary note for other policymakers in similar circumstances: deflation can be very difficult to predict in advance.

"In consequence, as interest rates and inflation rates move closer to zero, monetary policy perhaps should respond ... to the special downside risks - in particular, the possibility of deflation."

Deflation is not necessarily a bad thing. The world economy has enjoyed booms while prices were falling, during the 1920s, for example.

But it looks malign at the moment for two main reasons. First, there is a kind of good deflation that happens when productivity is high and the economy is robust. This is not that kind of deflation. Today's deflationary pressures come from excess supply of goods and industrial capacity.

Second, deflation is especially dangerous now because the US has unprecedented proportions of debt. Why does this matter?

In an inflation, money loses value, so the inflation-adjusted value of debt shrinks as the years go by. So inflation is kind to borrowers.

But in a deflation, the opposite holds. Because prices are falling, the real value of money goes up in a deflation. So the value of debt actually rises, and borrowers are punished.

This can create a debt trap, forcing firms and families into a spiral of cutbacks to service a growing burden of debt - even though they're not borrowing a cent more. This pattern of retrenchment and bankruptcy can create recession and depression.

"We've already got debt deflation stories - we do have quite a large number of firms that are facing those kinds of pressures from unexpected sort of deflation already," says former Fed governor and leading forecaster Larry Meyer.

"And, as slack builds up in the economy, we're likely to see inflation fall below the implicit target" of the Federal Reserve, says Meyer.

"And, we know in those situations, again, following the lessons of Japan, that the policy authorities have to be particularly even more aggressive about pushing inflation back [up] to its target."

The Fed's contingency plan includes drastic options. If the key official interest rate should hit zero and the Fed loses its ability to stimulate the economy in the customary way - the current rate is already at 1.25 per cent - it could

buy up masses of government debt, even private corporate debt and private real estate, as a way of pumping liquidity into the economy. Fed governor Bernanke also points out that big devaluations of the US dollar have helped defeat deflation in the past.

Ultimately, "the US government has a technology, called a printing press ... that allows it to produce as many US dollars as it wishes at essentially no cost ... Sufficient injections of money will always reverse a deflation", he says.

Morgan Stanley's Roach says that the Fed's speech and its actions "are all very carefully orchestrated; they are shaping policies as if deflation is going to happen - and that's a good thing, because it is such a dangerous time".

[imawit]

"Last week had all time highs in payoffs for refi and purchases of existing homes"

Just wanted to clarify that this number is the total US agragate of existing mortgages paid off which comes from refi and sales of existing homes. This figure has nothing to do with new home mortgages because there are now existing mortgages on a new home that get paid off when they are sold. It also has nothing to do with the number of homes bought or sold or their values.

[Pagey]

bttt

[Southack]

"I know its not a popular opinion, but I do belive we are heading for deflation. IMO, the evidence is mounting..."

It's good that you think that way, since so many influential people have been working so hard to convince you that's the true "reality".

But, agitprop aside, are we actually heading for deflation?

How can you tell?

Well, first of all, you need to understand deflation.

"Deflation" means that your Dollar buys more. When you have deflation, things cost less.

Is "deflation" always bad? Of course not. People wait for "sales" at retail stores because they want to take advantage of localized, temporary deflation. People shop at "sales" because they want their Dollars to go further and purchase more things.

OK, now that you have some grasp of the concept of "deflation", how do you know when it is on the way nationally, rather than just in isolated localities like in a store?

It's simple; you watch the "speed of money".

Oh, but wait Mr. Southack, how can it be simple if no one knows anything about the speed of money?

Well kids, that's the rub. All of the doom and gloomers, i.e. those tireless souls who want you to shake in your boots and be afraid that the sky is falling, don't want to tell you about the speed of money.

They'll craft elaborate "articles" designed to convince you that deflation is on the way, but they won't mention word one about the speed of money.

Heck, most folks don't even know what it means.

The "speed of money" is how fast financial transactions occur. Wow, they never told you that in the NY Times, now did they?!

I wonder how they missed that little tidbit?

Now, if the speed of money is increasing, and if your Dollar is buying more things, is that really BAD for our economy?!

Of course not!

In fact, why is it bad that your Dollar can EVER buy more things?

In other words, WHY are these gloom and doomers worried about deflation? Isn't that just like being worried about a store having a sale?!

Well, the REASON that the doom and gloomers worry about deflation is that they are uneducated (or that they are educated but deceitful).

The economists at the Washington Post and at the San Francisco Chronicle may not even know the difference between the speed of money and deflation.

Nonetheless, their arguments confuse the speed of money with deflation.

They worry that financial activity will slow down.

Well, SOMETIMES when prices go down nationally, financial activity DOES slow down. This is what happened during the Great Depression.

What they fail to comprehend, however, is that MOST of the time when prices go down, financial activity speeds up.

You lower the price on your house NOT because of deflation, but rather, because you want your localized financial activity to speed up; in other words, you lower the price to sell your house faster.

Likewise, stores have sales to increase their own speed of financial transactions.

Stores don't lower their prices in order to slow down the speed of their money! No, stores lower their prices to ENCOURAGE their financial activity to pick up.

But the Leftist media doesn't want you to know those simple facts. They want you to be frightened. They want you to think that the sky is falling.

Of course, none of what the mainstream media wants will help you determine if deflation is coming or not, and it certainly won't help you to discern if the deflation in question will be bad (i.e. slow down the speed of money) or good (i.e. increase the speed of money).

For that, you're on your own (well, with a little help from me).

[AdamSelene235]

In other words, WHY are these gloom and doomers worried about deflation? Isn't that just like being worried about a store having a sale?! Well, the REASON that the doom and gloomers worry about deflation is that they are uneducated (or that they are educated but deceitful).

I think deflation would be great especially for my Fannie shorts. I can't wait to see how the Fed will try and "fix" it. No doom or gloom here, if the fiat system is destroyed, I'll be dancing in the streets.

[Southack]

"deflation would be great especially for my Fannie shorts...if the fiat system is destroyed, I'll be dancing in the streets."

Someone may be kind enough to hint to you that your Shorts will be paid in that "fiat system"'s currency. One wonders if your goals are therefore contradictory.

[AdamSelene235]

Someone may be kind enough to hint to you that your Shorts will be paid in that "fiat system"'s currency. One wonders if your goals are therefore contradictory.

No, when you short, it is treated like any other sale. You are paid in fiat. Naturally, one can trade the fiat for something more, stable.

Fiat and bonds are useful in the transition to deflation, but may need to be abandoned when the Feds come to the "rescue".

[Mini-14]

"This is really simple but it will not happen because the manipulators always want a string attached and the public is waking up to this and also feeling it with the increase in debt as they spend and the actual fact that one may never get out from under the rock that is the burden of debt let alone be able to earn a comfortable wage and living without the slavery that debt imposes which pushes the drop in economic activity which then begets recession which then begets deflation. You can't have your cake and eat it too. "

Very well said.

[freeper12]

I think you may be missing the point....there real arguement is wether we are heading for deflation or not...not wether or not deflation will be good a thing thing...it won't if its anything but minor.

Things on sale are not deflation. Having a 30 year mortgage that you have to pay back with more expensive dollars in thr future is deflation.

[Southack]

Unless you know what the speed of money is doing (increasing or decreasing), you won't know enough about the future potential of deflation to make an educated guess about it.

[AdamSelene235]

Care to provide us with some data on velocity, Southack?

Falling prices decrease velocity as consumer choose to hold their dollars longer. In that sense, deflation can be self-reinforcing.

In turbulent times investors may also choose to store their savings in hard assets, thereby reducing velocity.

Currently money is being created like mad so there is little motive to hold on to it. This is why interest rates are depressed and I imagine velocity is high.

Personally, I think deflation and inflation are overly broad terms to describe our current situation. There are so many electric shocks and carrots build into our current system, it is difficult to know what the real market conditions are.

[Southack]

"Falling prices decrease velocity as consumer choose to hold their dollars longer. In that sense, deflation can be self-reinforcing."

Sure, sometimes that can happen, but it is the exception rather than the rule. Consider that sales PICK UP when a store lowers prices. Heck, if lowering prices didn't pick up sales speed, then why would anyone ever lower prices?! So it is pretty obvious that falling prices USUALLY increase the speed of money.

"In turbulent times investors may also choose to store their savings in hard assets, thereby reducing velocity."

Sure, but would you expect people to store their saving in hard assets if the value of those assets keeps decreasing? And if people decide to liquidate those assets rather than hoard them, will that increase or decrease the speed of money?!

[Southack]

"Care to provide us with some data on velocity, Southack? ... Currently money is being created like mad so there is little motive to hold on to it. This is why interest rates are depressed and I imagine velocity is high."

With the normal "conspiracy of incompetence" taken into account regarding the media, such data on the velocity of money is not always easy to obtain.

However, the media does publish some figures that can be used to ballpark the speed of money, such as the current target rate for the sales of new homes (running right around a rate of 960,000 to 1 million per year right now), so your guess that the speed of money is still high is a pretty good one.

[joanie-f]

Thanks for the ping, John. And for the eloquence, Leisler.

Oh our leaders know how to produce. No one beats us in producing studies, reports, collations, reviews, codes, laws, forms, rules, regulations, suits, counter sets of suits, counter-counter suits, appeals, pleading, reforms, programs, plans ….We could do even more if the last few holdouts would put down their engineering degrees and the last few loyal manufacturers quits being the kulaks of the Information Age .... Leisler

Well said! We are turning out communications/business degreed graduates from our colleges in record numbers, and our mechanical/civil/electrical/nuclear engineering, science, and higher mathematics classrooms are slowly finding themselves overrun with cobwebs. We have become a nation of paper-pushers (and paper requirers). When it comes to designing/making useful, nuts-and-bolts necessities, we leave that to the less elite cultures. What our myopia has failed to realize is that, when push comes to shove (i.e., when a few more 9/11’s are under our belt), all the paper, and all the red tape, in the world isn’t going to be useful in heating our homes, and moving from place to place, and keeping our food fresh, and providing shelter …. And when we are at the rest of the world’s mercy for all of those things, God help us.

Re: this article ….

It hardly pays to save in this country anymore. What investment exists that retains its growth potential outside of the potential for government economic interference? If one spends a significant amount of his time researching investment options and then places his money in what he believes to be a strong, reliable, reasonable-yield, long-term investment, odds are that, somewhere along the way, government interference (be it in the form of punitive capital gains taxation, fed money policy, etc.) will declare such individual, personal research and decision-making pretty much irrelevant. It’s called artificial manipulation of a free economy. So investing has devolved from a science to a crap shoot.

In that most insidious way, the government has robbed its citizens of the ability to enjoy financial stability, and (even more abhorrent) the ability to function as an individual on a level financial playing field. Bottom line: we are at the mercy of Congress and the Fed -- one of which is a rogue branch of government, and the other a completely unconstitutional one. And their powers (economically-intrusive legislation, taxation and the implementation of ‘monetary policy’) are two of the most liberty-erosive domestic forces at work in our society.

Two fascinatingly idiotic excerpts from this eye-opening article:

Deflation is not necessarily a bad thing. The world economy has enjoyed booms while prices were falling, during the 1920’s for example .... thirteen Fed staff economists

Chickens always come home to roost. Have these ‘thirteen economists’ ever studied what occurred in this country in the 1930’s? (helpful hint: 30’s follow 20’s)

The U.S. government has a technology, called a printing press .... that allows it to produce as many U.S. dollars as it wishes at essentially no cost .... sufficient injections of money will always reverse deflation .... Fed Governor Bernanke

We should all sleep real well tonight knowing that among our fed governors are those who possess the same mindset as the proverbial ditzy woman who believes that, as long as she doesn’t run out of checks in her checkbook, she can still keep spending (Keynes would be proud).

Two of the most corrosive (individual/private, as opposed to government) economic traits which have emerged in American society over the past decade have been (1) the enormous increase in personal debt, and (2) the sad fact that the financial markets are now ruled by a ‘casino mindset’ as opposed to an ‘investment mindset.’ (Pseudo) government monetary policy and lawmaking has encouraged both sad (fatal?) characteristics.

On a national level, the best way to return to economic sanity: demand economic rationality and accountability from Congress, abolish the Fed, and return to the gold standard.

On a personal level, the best way to avoid being pushed around like cattle in a pen in such an economic climate: get out of debt, and invest in precious metals.

[AdamSelene235]

With the normal "conspiracy of incompetence" taken into account regarding the media, such data on the velocity of money is not always easy to obtain.

YOU MEAN YOU DON'T EVEN HAVE ANY DATA !!!!!!!!!!!!!!!

You bring up velocity ever friggin time the D word is spoken as if it were some tailsman that wards off argument. I figured you at least had a chart or two to share with the class.

Sheesh.

[Southack]

No such luck!

[AdamSelene235]

No such luck!

ooooh!! (Throwing empty beer cans at the screen)

Change back to the pink bull...I found it easier to be annoyed with the pink bull than with my country.

Tell me, hypothetically speaking, if you were designing a country...would you set the fiat system the way it is now? Would you use fiat at all?

[RnMomof7]

Say thanks to the one world Government folks

[Southack]

"Tell me, hypothetically speaking, if you were designing a country...would you set the fiat system the way it is now? Would you use fiat at all?"

Keeping in mind that the reason to use "fiat" is so that all liquidity demands can be met (rather than starved ala the Great Depression), and that the reason to NOT use fiat is to prevent inflation/hyperflation via overzealous currency printing and government indebtedness, I'd use a hybrid of the two.

To wit: I'd back a paper-based currency with either land or oil, depending upon what the new government in question could most afford to squander, but I'd lean towards land (you can always tax it and they can't take it away) and let anyone claim possession of whatever appropriate amount of real estate was contained inside the new country's national parks/forests (adjusted for surveyed assets such as timber, oil, gold, water, et al).

In this way I could issue ALL of the currency that the new country's economy required (just like fiat currency), yet the "loss" of the ownership of the land would have a mitigating impact upon the future politicians of the country (just like a "backed" currency), such that freely running the printing presses would be forever unpopular.

But that's just me.

[AdamSelene235]

I would have chosen something that was:

1. Portable

2. Fungible

3. Durable

4. Easily sub-divided

5. In extremely limited supply

Land only satisfies 3,4 and 5.

I would also like to see free market competing fiat backed by various non-state players.

[Southack]

"Land only satisfies 3,4 and 5."

True, but reasons 1 and 2 favor individuals and pretty well doom governments (when combined into a currency that has 3,4,&5, at least). Substances that meet all of your requirements such as gold and silver and salt have all been used at various times in history, and none of those nations have achieved anything close to what the U.S. has accomplished. Remember, you asked me what I'd do for a new country, not what I'd do if I wanted the "ultimate" capitalist tool for individuals.

"I would also like to see free market competing fiat backed by various non-state players."

You've already got it. Various private currencies have included Green Stamps, Visa credits, airline miles, title insurance policies (or simply paper-based land titles), and a host of other tradable units.

People freely trade their paper currency for stock brokerage bits that exist only in the electronic ether. Many stock sites "give" new traders more electronic currency units than what are sent in to the brokerage, too (e.g. $50 deposited into your new account). Yet no paper Dollars went into those new accounts. Mere electronic bits were changed.

Likewise, there are privately backed systems that move "money" backed by gold (e.g. egold, or in the case of paypal, backed by credit) across the Internet.

Shoot, you name it and there is probably some form of private "fiat" currency system out there somewhere.

But why get all worked up about a currency? All that it does is facilitate trade and store value. Life would simply be less efficient without it, and life can only get marginally better due to improving it. Surely there are less efficient aspects of life that could use more tweaking than our currency; concentrate your efforts on those less efficient areas and you're liable to get a much better return on your efforts.