Saturday, August 10, 2013

Inflation versus Deflation Revisited

It has been a couple of years since I first blogged on the topic of Inflation versus Deflation and I think it is time to revisit the topic.  I may be off in my prediction on this topic or I may have been too early; I am not sure.  We certainly haven’t had deflation, however. 

Treasury prices probably topped in 2012.  The top in bond prices before that was in 1946.  Bond market cycles are really, really long ones!  And we have probably begun to march down the path of a new Treasury bond cycle which will last a long time as well even if the Federal Reserve’s program of Quantitative Easing continues for some time.  I believe we are bound to see some inflation as this new cycle blossoms as well.  In this blog I have indicated (back in March 2011) that I believe that inflation will ultimately win over deflation (we have had low inflation in the CPI – more so in asset prices – since the time of my initial blog on the topic but not the stagflation I envisioned) and I continue to believe that more inflation will be the result if the US continues down its current path.  I no longer believe that the initial effects of Quantitative Easing in the short term (<12 months from now) will lead to significant consumer price inflation, however.

Why?  The rise of the baby boom generation and the concurrent rise in the overall level of credit with that generation have put the US in the position where it is today.  The expansion of the credit markets nicely parallels the rise of the stock market from 1982 until the present.  The US is de-leveraging private sector debt as the baby boom generating ages, slows down consumption and corrects some of its prior excesses – transferring private debt to public sector debt.  The entire process of de-leveraging will take some time to work off and is disinflationary for consumer prices at this time.  With the baby boomlet generation coming into prime consuming years, immigration reform on the horizon, and continued growth in US population, I do not see the US becoming the next Japan so I do not see this as a long term deflationary trend, but simply a medium term disinflationary one.

Quantitative Easing is not having a truly inflationary effect due to the de-leveraging process because the velocity of money has dropped so dramatically.  This drop is unprecedented in US history.  Moreover, commercial banks face regulatory requirements they did not have years ago and simply cannot make the loans that they used to make. Liquidity is available from the Fed, but that is not the real problem. Private capital from the capital markets or earnings to meet capital requirements is simply not available.  Banks must hold capital to backup a fixed percentage of their assets at risk – including their loans – and they cannot expand their balance sheets without this additional capital.  Just the eight biggest US banks have holding company and insured bank subsidiary shortfalls of $63B and $89B respectively.

This capital for banks is simply not available today.  If all the banks in the US are included the capital shortfall is probably well over $1 trillion.  The "money" from the Fed's Quantitative Easing program has to go somewhere.  It doesn't just disappear into thin air.  It can be used as collateral in margin accounts.  The Fed inspired inflation that exists today winds up in asset prices or in goods and services (e.g. rent) closely related to specific asset prices where there is a substitution effect.  The “money” from Quantitative Easing has been going to places like the stock market and back into real estate where deals are being done for cash or relatively little leverage.  It has not yet been able to find its way back into the broader economy in any other significant manner – yet.  Tighter capital requirements will not remain an impediment to lending on banks indefinitely.  Clever bankers will soon figure out ways to get around the current regulations and inflation will take hold when assets once again become monetized more readily.  I believe it is only a matter of time.  The incentives to do so are extremely powerful.  There is too much fee income for the bankers.


Moreover, some inflation will help resolve the problems of how to de-leverage the public sector balance sheet and how to pay the interest on the public debt in the interim when interest rates begin to rise.  But it is a very fine line before inflation expectations get baked into the system or begin to spiral out of control.  As with the effects of Quantitative Easing, there will be winners and losers in the ensuing inflation.  Sadly, I don't believe our leaders are going to lose too much sleep over the consequences. 

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