Inflation vs. Deflation Debate

THE INFLATION vs. DEFLATION DEBATE
The economist John Kenneth Galbraith once said, "The only function of economic forecasting is to make astrology look respectable."  Even so, it has not kept a great many pundits from engaging in the inflation vs. deflation debate. Economists are worried about prices*but they disagree about whether prices are going up or down.

They ruminate over whether the Federal Reserve will be more worried about the threat of inflation in the long-term horizon, or deflation in the short-term? The reason that this is of more than academic concern to homebuyers and borrowers is because inflationary expectations in the form of rising bond yields often results in higher mortgage rates and deflationary expectations (decreasing yields), lower ones. The trend toward higher interest rates has already begun. Since March, the yield on the 10-year Treasury has jumped from 2.5% to 3.8%, sending prices which move in the opposite direction down an astonishing 34%. As the yields march upwards, mortgage rates usually follow and a major justification for the government*s massive deficits, the cheap cost of borrowing, will disappear.

The bond market is very savvy about predicting where interest rates are headed. But, let me caution the reader about a common misunderstanding. As I said in the paragraph above inflationary expectations (rising bond yields) OFTEN result in higher mortgage rates, but the one is not tied to the other. Many people assume an implicit relationship between the bond markets and mortgage rates. The financial press has been complicit in linking mortgage rates to the U.S. 10-year Treasury Note. This happens because though financial reporters may understand the bond markets they do not understand how mortgage rates are determined. Mortgage interest rates and the intra-day re-pricing that occur are based on the performance of mortgage- backed securities, not U.S. 10-year Treasury Notes.

POINT
Inflation hawks argue that the recent rise in oil prices (from $35 to $70 over the same 6 month period), the dollar's loss of value and the recent rise in yields on U.S. Treasuries are all signs that higher interest rates are just around the corner. These economists claim that inflation in every instance is always a monetary phenomenon*that is, too much money chasing too few goods. They say the seeds for inflation have been sown by the Fed's dramatic expansion of the money supply over the past year in its extraordinary efforts to keep the economy afloat.

While they allow that borrowing remains relatively cheap by historical standards, government deficits and inflation will change that picture over the next few years. They point out that the trend towards far higher rates has already begun. As evidence, they cite the near doubling of the yield on the 10-year Treasury Note in the past 6 months. Another possible cause for boosting treasury yields is that China is a key buyer of U.S. Treasuries might close its wallet because of concern over the U.S's credit quality. They reason that as yields march upwards, mortgage rates will follow, and the cheap cost of borrowing, will disappear. For these reasons they see inflation as inevitable.

To avert disaster they believe the Fed needs to throttle back quickly on the various programs it has created to pump cash into the economy, even if the U.S. economy is still struggling. If the Fed doesn't act, it could risk even worse problems down the road*especially if long-term bond yields and the lending rates tied to them continue to rise.

COUNTERPOINT
But the opposition argues the economy is still so weak that deflation, or a drop in prices, is the more serious threat. A Labor Department report said that American wages fell 1.2% as unemployment rose to 9.5%. They aver that unemployment and debt will make rising prices a non-issue and cite the recent decline in the Consumer Price Index (CPI), the government's key inflation measure which posted its largest 12-month drop since May, 1950. As further proof of an emerging trend they point to the fact that the so-called core CPI which strips out food and energy prices, was negative for three consecutive months (March - May). Moreover, they say that prices are a lagging indicator in deflationary contractions and point to borrowers* lines of credit being frozen, credit limits being cut, and LTVs being lowered on mortgages are precursors of falling prices. A similar contraction is occurring among state and municipal governments. Many have budget shortfalls in the millions and billions which will necessitate their having to slash spending to the bone. History has shown that weak economies drag down inflation. Businesses unable to make a profit in an environment of declining prices inevitably cut production and lay off more workers which intensify the deflationary spiral. The Great Depression and Japan's so-called Lost Decade of economic stagnation are both well-documented examples of the damage that deflation can cause.

But what about all the money the government is pumping into the system? Proponents claim that by itself it is not inflationary. They claim that Gross Domestic Product (GDP) is equal to money times its turnover, or velocity, which is basically, the speed with which people spend it. In the last two quarters, the money supply has grown at 14% but the velocity has declined by about 17%, so nominal (non inflation-adjusted) GDP fell 4.5%. Deflation proponents believe that excessive debt controls all, or nearly all, other economic variables. The reason that velocity is down, they say, is that in financially perilous times, people are more interested in trying to get out of debt rather than increasing it, which means the economy cannot grow, and if there's no increase in demand, there can be no increase in prices.

The deflationists envision that high unemployment, low factory utilization, and real estate vacancies (in both commercial and residential sectors) are underlying reasons
that the economy will be weak for years. And, they argue even if inflation and interest rates were to rise, this would be short-lived since the economy would quickly stall because with widespread unemployment, wages would seriously lag inflation. Thus, real household income would decline and truncate any potential gain in consumer spending. As a consequence, they forecast that with core inflation at zero, a deflation is a real possibility for 2010 or 2011.

SYNTHESIS
As for China liquidating its sizable bond holdings, it would severely decrease the value of its $1 trillion investment. Another reason that I believe fears about inflation are overwrought, is that the Fed knows how to fight it with higher interest rates and tightening the money supply. But if a nation goes into a deflationary spiral, it's very difficult for it to extricate itself. Ben Bernanke, the Fed Chairman, is a longtime student of the Great Depression and well-versed as to its causation. It is why, last December, the Fed cut the Fed Funds rate to virtually zero and has since engaged in a policy known as "quantitative easing" to restore the flow of credit.

The central bank has, also, created a mountain of bank reserves to fight the financial crisis. These very reserves have filled the inflation-spooked economists with apprehension. But their concerns are misplaced. In normal times, banks don*t want excess reserves, which yield them no profit. So they quickly lend out any idle funds they receive. Under such conditions, Fed expansions of bank reserves lead to expansions of credit and the money supply and, if there is too much of that, to higher inflation. In abnormal times such as these, providing banks with the reserves they demand, fuels neither money nor credit growth and is therefore not inflationary. Rather, it's tantamount to what the Fed does every Christmas season, only on a grander scale. It puts additional currency into circulation during this prime shopping period because people demand it, and then withdraws the *excess* currency in January.

Inflationists and deflationists are concerned about this last step because the timing has to be spot on: if the Fed withdraws the reserves too late, you get inflation; if it does so too soon, we remain mired in a recession. While the Fed is not infallible, there are a couple of important points to note:

1. It is not incompetent: it does have an exit strategy it has committed itself to an inflation target of just under 2 percent. Naturally, there are no guarantees that the Fed will hit the mark. If it were to miss, the result might be inflation of 3 percent or 4 percent but not 8 or 10 percent.

2. The Fed will begin the exit process when the economy is still below full employment and inflation is below target (pulling away the punch bowl just as the party starts to get underway). So, the Fed shouldn't have to raise rates or contract the money supply by much.

As we've seen, given the unusual nature of the current economic environment, economists are having a hard time figuring out if it's inflation or deflation that we need to be concerned about. In most cases life is not an either/or proposition and reality resides somewhere between the two extremes. I expect to see the economy struggle for many months to come and the housing market, longer still. But, the reasons cited by the inflationary camp do not strike me as credible in the near term for the very reasons cited by the deflationists. And, rising commodity prices have eased some worries, though not all, about a deflationary spiral.

Thus far, this year, ten-year bond yields and stock prices have marched in lock-step: When yields hit highs of almost 4%, stocks also soared, and when bonds began to drop, so, too, did equities. I believe that we are in the midst of what amounts to a two-tiered interest rate environment.

Barry Knapp, an equities strategist at Barclay*s Bank discovered through regression analysis that there exists two distinct interest rate mileus that influence the economy a higher and a lower.  When the yield on the ten-year bond is [was] 5% or lower, the correlation between the yield and equities tends to be positive, but when it is above, then it becomes negative. As long as we are in a low rate environment, it appears stocks will rise in concert with bond yields. On the other hand, should rates climb past 5%, rising yields cut into companies' earnings and slow the overall economy. Right now, though, stocks are still undervalued compared to interest rates.

So, I expect to see the economy occupying a middle ground with prices moving largely sideways in the near term and moderate inflation 3-5 years down the road. Our economic recovery will no doubt be hampered by unemployment, predicted to reach 10% by 2010 and elevated for years afterward. And, the fact that families are saving more of their income in these uncertain times is another development thwarting consumer stimulus efforts. Our Gross Domestic Product is expected to shrink about 1.5% this year. Also, the recession that the U.S. is experiencing is a global phenomenon, not merely national in scope. Challenging as it is, what we're going through is not nearly as harsh as what much of the rest of the world is undergoing. As a consequence, I believe it will take years for economies to revert to normalcy and some markets (like housing) even longer. Because of weak demand and high unemployment a protracted, jobless recovery is expected, a U-shaped one with a relatively flat bottom. I believe that inflation will return but that it will be moderate in the nature of 2-4%. If I'm wrong, blame it on John Kenneth Galbraith--my astrological sign is Taurus so despite some of my comments I*m bullish by nature.

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